Graham Campbell, CEO, explains why we never try to time the markets…

Why we expect to sell too early!

 

As a fund manager, one of the most frustrating aspects of the job is to sell a share in a business and then have to watch the price continue climbing.  There is some truth in the view that you only remember the ones that got away, but they often cause more personal pain than the investments that worked to plan.  We have had several examples of this incidence this year, when we sold Apple, LVMH and Microsoft, all at very healthy profits, only to watch the shares keep rising above our selling price.

The inverse is also annoying: when you buy a company when the share price has fallen, just to watch it keep going down.  I would argue that both events are completely unavoidable and while we all have the “if only” moments, they are actually far less damaging than potential errors involved in attempting to call the peaks and troughs.

Indeed, the errors of not buying when shares are cheap and not selling when they are expensive are potentially much more serious and can be disastrous.  Over the years, I’ve watched fund managers try to time their purchases to the trough of a share price decline.  Ignoring the retrospective perspective of this issue, the intention may seem noble and even common sense.  However, the reality is quite different; once you leave behind the valuation piece, then you enter the speculative zone and even the finest minds cannot predict random market movements.

A typical occurrence is a fund manager setting a low-price target on a falling share.  This usually has more to do with a level that is not related to valuation.  Unfortunately, once they are set, the manager is often anchored to this target and if the price rallies, the long-term purchase opportunity is lost, sometimes for the sake of a per cent or two.

More dangerous is the resetting of price targets into a rising market.  This is more common than one might think!  Price targets are raised because of the price, not the prospects! This can result in a manager losing objectivity and with increasing confidence, moving from traditional valuation measures to other less demanding or tested metrics: ‘the share is just cheap and has a long way to go!’  Memories of the tech bubble and more recently crypto currencies should highlight the dangers of this approach!

Process is important and clients are rightly concerned when managers appear to allow some drift to take account of ‘market conditions’ or invest in areas where they have little track record or obvious expertise.

There are three reasons why we sell a share at Saracen:

  1. Valuation: where we feel the share price fully reflects the prospects for the business.
  2. Worst Case: where are increasingly concerned about the deterioration in our Worst Case estimates and probability of occurrence.
  3. Portfolio Upgrade: where we can find a similar business with lower risk characteristics, such as lower valuation, stronger balance sheet, and less severe or likely Worst Case.

While there are dangers in blindly following one valuation metric, we tend to view a 5 year PER of over 15 times as expensive.  History has shown that investors overpay for growth.  While we also adjust for cash generation and balance sheet strength, our rule of thumb is that if a company cannot reach this level after 5 years, then investors are unlikely to achieve an equity like return.

The chart below considers Microsoft.  We initially purchased at $26 in June 2011 and we sold this year at $106.  In descending order, the top chart graphs the share price to Y1 forward consensus earnings for the past 5 years.  The following charts show the respective forward consensus PER and Yield. (source: Bloomberg)

Microsoft is a fine company.  It makes impressive returns on capital, achieves high operating margins and has a cast iron balance sheet and attractive prospects.  This was true over our entire period of share ownership.  The market capitalisation of Microsoft is now around $880bn.

Fund flows to tech remain strong and the share price may continue to rally.  We know we cannot predict with any confidence in which direction the share price will move with the equity market.  If we had to guess, we would probably estimate it will drift higher!  Nevertheless, the forward PER is now over 26 times earnings and the yield is less than 1.6%.  The shares are expensive on our assumptions of earnings growth.  We do our best to avoid speculation and unnecessary risk; accordingly the shares were sold.

Inevitably, there are occasions where we do get it wrong and sell too early.  We tend to be conservative in our assumptions and sometimes our forecasts are too low and reported earnings continue to positively surprise. We made a healthy profit from our investment in LVMH, but earnings  continued to be upgraded and the share price has responded accordingly.

As noted previously, we also sell when the worst case is becoming increasingly unpalatable and more probable.  The reported earnings may still justify a rising share price, but the increasing risk in the investment may result in the disposal of the shares.

The benefit of a strict process is that it gives managers the confidence at times of stress to buy cheap shares and sell expensive ones.  There is still a large margin of profit between the two actions.  In practice, this means we often buy and sell before the troughs and the peaks.

While this can be an uncomfortable practice, especially as we wait and watch share prices drift higher, it avoids the irrational exuberance and ‘it’s different this time’ mentality that is always present in some business valuations during the latter stages of a bull market.

Graham H Campbell

Joint Manager of TB Saracen Global Income & Growth

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Graham Campbell & David Keir give the latest updates in portfolio activity in TB Saracen Global Income & Growth Fund…

Two new holdings: Carnival Cruises and Valeo

We are frequently asked whether we meet company management prior to investment.  The reality is that we are unsure about the value of these meetings, as most information is already available, and management are rarely impartial in their assessment of outcomes.  However, in the two cases discussed below, the meetings were sufficiently interesting to spur us to further analysis.

Some of our best decisions have been when we invested in global leading companies that were out of favour.  Our two recent acquisitions – Carnival Cruises and Valeo – fit this bill, albeit for different reasons.

We held Carnival Cruises ($59) at the launch of the fund in June 2011 but sold the shares at the start of 2015 after a rise of 25% due to the valuation becoming stretched.  We continued to follow the company as we like the long-term trends and Carnival’s position in the marketplace.  We have continued to regularly meet management over the years.  Recently, one of those sessions was the trigger for a closer look at our Carnival model.

Since the start of the year, Carnival shares suffered as a very strong 2017 hurricane season led to postponement of bookings for Caribbean cruises in 2018.  The market became increasingly concerned over potential discounting to fill capacity.  In fact, management was relatively relaxed about the ongoing booking season and saw customers coming back without having to lower ticket prices.  In general, the story looked much better than it had in the recent past.

As is so often the case, the market de-rated the shares on the short-term outlook, ignoring that the long-term industry drivers are actually improving.  These include amongst others:

  • the main target group (US retirees) is still growing, has plenty of dispensable income and should benefit from tax cuts
  • cruises appeal to millennials and younger people as they are hassle free holidays with lots of experience
  • cruising is still a small part of the overall travel industry and taking market share
  • cruising is becoming more main stream with 33% of passengers who have taken a cruise in the past three years having a household income of less than $80k

Investors are also concerned about the increase in capacity over the next five years.  Carnival operates just over 100 ships with another 19 ordered through 2022.  This represents a 5.4% CAGR in capacity versus 5.6% for the industry.  Some investors are concerned that this will create a supply glut as it outstrips the industry demand growth rates of 4-5% p.a.  However, some ships are earmarked for the fledgling Chinese market where cruising is still in its infancy.  Stripping out the Chinese allocation, the capacity growth drops to an average of 3.4%, which is in line with forecast industry demand.  We believe Carnival has enough pricing power to fill additional space at full price.

Additionally, Carnival has various options to increase its margins.  Bigger and more efficient ships will offset the rise in fuel costs; more onboard spending will contribute positively to operating profit, as will high end tours and excursion to Carnival owned resorts.  We bought the shares at 14.2x 2018 PE and 9.8x 2022 PE with a yield of 2.8%, similar metrics to when we originally bought the shares.  By comparison, when we sold our holding previously in 2015 they were trading at 19.8x Y1 PE with a 2.1% yield.  Providing the company and industry outlook remains favourable and the valuation attractive, we are happy to back the shares again.

Our interest was drawn to Valeo (€40) in a different way.  It appeared on our weekly screen next to many other car companies and automotive suppliers.  The whole sector has been de-rated this year due to the increased trade war risks between China and the US, as well as the recent weakness in auto sales on a global basis.  But as so often, short term pain offers long term opportunity.

Valeo is number one or two in each of its four divisions on a global basis (comfort & driving assistance, powertrain systems, thermal systems and visibility systems).  In short, it is exposed to many of the growth technologies.  It supplies all the major OEMs and has a well-diversified customer and geographical portfolio.  However, the main reason – next to valuation – that attracted our interest is Valeo’s growth profile.  The company has consistently outperformed the wider automotive market in recent years.  The order book grew at a compound rate of 14%per annum from 2008-17 and increased to 17% in 2017.

The driver behind this is Valeo’s investment in R&D (6% of sales) and capex (10% of sales) in recent years.  This investment has helped cement Valeo’s position as one of the leading suppliers for electrical and autonomous vehicles over the next decade.  While R&D will stay at elevated levels near term, capex should peak in 2018. Source: Valeo

The company, peers and OEMs cut their guidance for 2018 due to lower auto sales in recent months, mainly in Europe and China.  This is partly due to the trade war rhetoric between China and the US and to the uncertainty over the introduction of the WLTP (worldwide harmonized light vehicle test procedure).  In the wake of the diesel scandal, new testing procedures were introduced globally in 2017.  As of September 2018, all new car registrations must apply with WLTP.  Many consumers are understandably still confused and have postponed purchases until they have more clarity.

Following a reassuring meeting with the company, we believe investors have generalised assumptions across the sector.  The fact that Valeo is one of the leaders in R&D for next generation cars, has had no cancellations for its mid and long-term contracts and continues to see strong order intake gives us comfort for the mid to long term.  We know the short term will be volatile, which is why we initiated a small position.  We will top-up on any weakness.  At 10x 2018 PE and 6.5x 2022 PE, we think there is a lot of pessimism included in the price.  The dividend yield of 3.2% is safe.

Feel free to contact us if you have any questions regarding the recent activity in the fund.

Many thanks for your continued support

David Keir (David@saracenfundmanagers.com)

Graham Campbell (graham@saracenfundmanagers.com)

Co-Managers, TB Saracen Global Income & Growth Fund

Important Information: The views and opinions contained herein are those of the author’s, and may not necessarily represent views expressed or reflected in other Saracen Fund Managers Ltd communications, strategies or funds. This material is an opinion piece and intended to be for information purposes only. This material is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The material is not intended to provide and should not be relied on for accounting, legal or tax advice, or investment recommendations. Reliance should not be placed on the views and information in this document when taking individual investment and/or strategic decisions. Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested. All investments involve risks including the risk of possible loss of principal. Information herein is believed to be reliable but Saracen Fund Managers Ltd does not warrant its completeness or accuracy. Reliance should not be placed on the views and information in this document when taking individual investment and/or strategic decisions. Some information quoted was obtained from external sources we consider to be reliable. No responsibility can be accepted for errors of fact obtained from third parties, and this data may change with market conditions. This does not exclude any duty or liability that Saracen Fund Managers Ltd has to its customers under any regulatory system. The data provider and issuer of the document shall have no liability in connection with the third-party data. The Prospectus and/or saracenfundmanagers.com contains additional disclaimers which apply to third party data. Regions/sectors shown for illustrative purposes only and should not be viewed as a recommendation to buy/sell. The opinions in this document include some forecasted views. We believe we are basing our expectations and beliefs on reasonable assumptions within the bounds of what we currently know. However, there is no guarantee than any forecasts or opinions will be realised. These views and opinions may change. Saracen Fund Managers Limited is Authorised and Regulated by the Financial Conduct Authority.

 

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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

 

Important Information: The views and opinions contained herein are those of the author’s, and may not necessarily represent views expressed or reflected in other Saracen Fund Managers Ltd communications, strategies or funds. This material is an opinion piece and intended to be for information purposes only. This material is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The material is not intended to provide and should not be relied on for accounting, legal or tax advice, or investment recommendations. Reliance should not be placed on the views and information in this document when taking individual investment and/or strategic decisions. Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested. All investments involve risks including the risk of possible loss of principal. Information herein is believed to be reliable but Saracen Fund Managers Ltd does not warrant its completeness or accuracy. Reliance should not be placed on the views and information in this document when taking individual investment and/or strategic decisions. Some information quoted was obtained from external sources we consider to be reliable. No responsibility can be accepted for errors of fact obtained from third parties, and this data may change with market conditions. This does not exclude any duty or liability that Saracen Fund Managers Ltd has to its customers under any regulatory system. The data provider and issuer of the document shall have no liability in connection with the third-party data. The Prospectus and/or saracenfundmanagers.com contains additional disclaimers which apply to third party data. Regions/sectors shown for illustrative purposes only and should not be viewed as a recommendation to buy/sell. The opinions in this document include some forecasted views. We believe we are basing our expectations and beliefs on reasonable assumptions within the bounds of what we currently know. However, there is no guarantee than any forecasts or opinions will be realised. These views and opinions may change. Saracen Fund Managers Limited is Authorised and Regulated by the Financial Conduct Authority.

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Ellie Sluys, Communications Manager at Saracen Fund Managers, fills us in on her typical day…

How do you start your working day?

I’m usually woken abruptly around 7am by my two little boys who are full of energy from the minute they wake up. Despite being very organised, mornings are always a little chaotic with school bags being packed, breakfast being eaten and the inevitable missing shoes/socks/books!

After dropping the kids off at around 8.30am, I then walk to work through Stockbridge and up to the West End while sipping a coffee and listening to music. Edinburgh is a beautiful city – on a sunny day, it’s hard to imagine a more scenic commute.

Image result for stockbridge edinburgh sunny

Tell us about your career so far.

Having completed several internships with the Financial Times, I began my career as a graduate working at a financial newswire before later moving into PR. I worked for various large London PR agencies which were fast paced and certainly provided a steep learning curve! I finally made the move in-house, working as a PR Manager for a branch of The Hut Group in Brighton.

After a career break to spend time with my two young sons, I joined Saracen Fund Managers in September 2017 and haven’t looked back!

What does a typical day at Saracen Fund Managers look like for you?

My role is very varied and two days are rarely the same.

Depending on the week of the month, there may be fund factsheets or quarterly reports to check, edit and distribute, followed by client communications. When contacting clients and prospects, it’s important to know the fund performance and understand the reasons behind it so I will usually take some time with each of the fund managers beforehand to discuss.

On a day to day basis, I will speak with our PR agency to set up interviews or draft comment for the fund managers. I will then share any coverage, blogs or other relevant updates over our social media channels. I will also converse with platforms over creating guest content for their portals and social channels as a way to reach a new audience.

Speaking with our fund administrators regularly is essential to analyse flows into and out of the funds that week and their origins.

The fund managers travel frequently so I will book meetings with current investors, then research and pitch to new business prospects in those locations.

As with many communications professionals, I have recently been wrestling with the dreaded GDPR so will be relieved when that is completed!

What skills are necessary to succeed at your job?

First and foremost, as a boutique business, it is essential to have a ‘can do’ approach and be happy to roll up one’s sleeves and get involved. One day I might be speaking to asset managers controlling billions of pounds and another day I might be arranging flowers for the boardroom! I relish the variety and exposure to many elements of the business I get from working within a small team.

My role involves large amounts of communication so it’s vital to be friendly, outgoing and personable.

Due to the varied nature of the role, it’s also necessary to be extremely organised, efficient and have a willingness to learn on the job.

What is the company culture at Saracen Fund Managers?

As a boutique business, we are a tight knit bunch and unusually for our industry, we have a very flat structure. Each member of the team is encouraged to voice their opinions and join the debate – even in areas that are outside of their role. I am always welcomed sitting in on investment meetings and the CEO & fund managers listen in on marketing/PR meetings. We find this gives us alternative perspectives that we might not have otherwise considered.

The team here appreciate the importance of a strong work/life balance – we work hard during office hours and usually all leave on time to get back to our families.

What role does technology play in your day to day working life?

Technology is vital to my day to day life on a personal and professional level. Within the business, most of our communications is carried out electronically through our marketing systems, over email and on our social platforms.

Personally, my entire life is stored within my iphone!

Any favourite haunts for lunch?

 As a relatively healthy eater, I try to prepare lunches for work to keep myself on the straight and narrow, however, I am passionate about great coffee and Edinburgh has many superb coffee shops.

 Wellington, Castello, Fortitude and Cairngorm are particular favourites and are fortunately all only a small detour on my way to work!

 Image result for cairngorm coffee

How do you relax in the evening after a long day?

 After picking up my kids, we usually eat dinner together before they go to bed at around 7pm. After that, I will usually try to squeeze in a work out before enjoying a glass of wine and a good book. I am currently working towards a CFA qualification so have recently swapped novels for text books!

On a rare night without the kids, there are many fantastic bars and restaurants in my neighbourhood of Stockbridge with favourites being The Last Word cocktail bar, Hamilton’s pub, Kenji Sushi and Nok’s Kitchen.

 

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Bettina Edmondson, Global Investment Analyst, examines valuation in the staples sector and why she thinks it’s still not ‘worth it’…

At Saracen, valuation is at the heart of everything we do.  We remain convinced that buying a good business at an inflated valuation is a poor investment.  For most of the last three years we have talked about the stretched valuations for many businesses in the staples sector, where the appreciation in their share prices appeared more related to their comparison to bond yields, rather than any improvement in their earnings outlook.

EU Staples performance relative to the market vs. 10Y bond yields

The tide has now turned.  Global economic growth has persisted and there is less requirement for Central Banks to buy bonds to depress interest rates.  The Fed has turned from a net buyer of bonds to a net seller and the European Central Bank (ECB) has reduced the amount of bond buying.  The combination of these factors has led to a fall in bond prices and rise in yields.  This process towards normalisation still has some way to go (see chart below).

Long term bond yields

There are now expectations that the Fed might hike 3 or even 4 times this year, followed by another 4 times next year.  While the ECB is quite a bit behind, growth in the Eurozone is strengthening and there is potential for a rate rise towards the end of 2018.  We would expect this scenario to maintain downward pressure on bond prices.

As this unfolded, the staples sector began to underperform the wider market towards the end of 2016 and continued to do so in 2017 and year to date.  Some of this underperformance can be attributed to disappointing results from the underlying businesses.  The derating, as measured by a declining price-earnings ratio has accelerated since the start of this year:

EU Staples valuation vs. 10Y bond yields

This has affected almost all shares in the Staples sector:

Derating / rerating of Staples companies YTD

While some market participants think the underperformance has run its course, we believe it is only the beginning of a longer-term trend.  Competition remains fierce and we expect earnings growth to remain subdued while the shares are often still on demanding valuations.

MSCI EU Staples FCF yield

Valuation is not the only obstacle holding us back from investing in this space at present.  We have said for a while that the dividend yields on the Staples are not sustainable. In specific, we have highlighted Coca-Cola for the last 2 years as an example where the dividend pay-out ratio has reached unsustainable levels and where shareholder returns went hand in hand with increased leverage.

Coca-Cola Fundamentals

Over the last 5 years Coca-Cola has reported declining EPS (from $2.12 in 2013 to $1.93 in 2017), yet its dividend increased every year (from $1.12 in 2013 to 1.48 in 2017).  Looking at the cash flow statement, the total dividend payment from the company represented 62% of FCF (free cash flow) in 2013.  This rose to 119% in 2017!  It is quite clear that the only way Coca-Cola was able to continue its progressive dividend was by increasing its leverage.  In fact, over the last 6 years its net debt to EBITDA ratio rose from 1.2x to 3.1x.

Coca-Cola is not alone in adding leverage. Across the staples space, net debt has tripled since 2009 (from 1x to 3x), while the rest of the market actually de-levered from 5.3x to 3.3x.

                Staples’ Net Debt to EBITDA versus the market   

                 Staples’ Net Debt to EBITDA relative to the market   

Part of this increased leverage was used to return money to shareholders via dividends and / or share buy backs, which boosted earnings per share. However, some companies also increased borrowings to acquire businesses at arguably stretched valuations in order to bolster underwhelming top line growth.  For example, ABI Inbev’s net debt/EBITDA rose to 6.6x after the SABMiller acquisitions.  Reckitt Benckiser bought Mead Johnson with debt (and equity) and geared up to 3.7x, while Danone’s leverage ratio reached 4.2x after it acquired WhiteWave.  The list goes on.  Extended leverage ratios can be accommodated in high cash generative businesses.  However, cash generation within the Staples sector has slowed in recent years.

When interest rates rise and companies have to refinance their relatively stretched balance sheets at higher interest rates there will be an impact on earnings and cash flow.  It is possible that dividends will be under pressure.

All this is happening at a time when the fundamental backdrop for FMCG companies has deteriorated.  We have long argued that top line growth expectations are optimistic.  The average sales growth over the last ten years was 5%.  However, this was inflated by the Emerging Market boom in the early 2000s.  Over the last 5 years this growth rate has more than halved to 2.3%. We do not believe we are going back to the 5% growth rates that many investors are expecting.

MSCI EU Staples sales growth

Many companies are experiencing increased competition from niche players who are more nimble and better attuned to consumer needs and wants.  In particular, e-commerce is offering greater choice to consumers and negating economies of scale.  When volumes are persistently low, especially in developed markets and when pricing power is eroding, revenue growth is under pressure.

This was reiterated in a recent study by Bain and Company, which also does not expect FMCG organic revenue growth to bounce back to historic highs.

FMCG organic growth

When we first launched TB Saracen Global Income & Growth, we had 27% of the portfolio invested in Consumer shares.  Today, this stands at 4%. Several companies are resurfacing on our weekly company screens.  Some Staples companies are amongst the world’s best run companies and we expect to own them again in the future, but at a price that more suitably reflects their earnings growth.  However, the combination of increased leverage, still elevated valuations and a subdued growth outlook, means that we still think it’s too early to reinvest.

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Scott McKenzie, Manager of the TB Saracen UK Alpha and TB Saracen UK Income Funds, tells us about his typical day…

Describe a typical day in your life.

My alarm goes off at 5.45am and by that point my cocker spaniel Lucy will be keen to explore the back garden. Living in Glasgow but working in Edinburgh means I have to get organised pretty quickly and I am out of the door by 6.15am each day. I have a short walk to my local train station which connects to Glasgow Central and I usually make the Edinburgh train with a few minutes to spare, coffee in hand if all goes well. At that time of day, I always have a table to myself which I use to scroll through the Times on my iPad, look at stock research and have a quick skim through company results out that morning. If I’m in the mood I catch up on the latest music on my wireless headphones via Spotify (I recommend the Bowers & Wilkins P7’s – pricey but high quality!). By the time I get to my office in central Edinburgh at 8am, I hit the ground running and have an initial view of the day’s big events.

 

 

Tell us about your career to date.

I have been fortunate to work in three great cities during a 25 year career in fund management – Glasgow, London and Edinburgh. They are all very different but brilliant in their own ways. I started my career with Britannia (latterly Ignis) in Glasgow as a trainee analyst. I was there at a time of rapid growth for the business during the 1990’s, a period when our UK equity fund performance was very strong. I moved to London to work for Norwich Union in late 1999. With almost uncanny timing, NU merged with Aviva in March 2000 just as the tech bubble burst and markets collapsed. Integrating the two businesses in such difficult conditions was a trying task but it was a big learning experience and I worked with a number of great people, many of whom I am still in contact with. Having enjoyed the bright lights of London for six years, I moved to Martin Currie in Edinburgh in 2005. The business was prospering at that time but the financial crisis of 2008 had a big impact on what was a purely equity fund management business and I left in late 2009. I spent five years outwith the industry helping my wife set up and run a catering business before Saracen asked me to join them in mid 2014. I was delighted to be part of what was a small but exciting venture and in April 2015 we launched the Saracen UK Income fund.

What was the biggest learning curve in your career?

Both the 2000 and 2008 market crashes were painful at the time but offered huge learning opportunities. On a personal note, 2008 was tougher from an investment performance perspective and led to a great deal of introspection and change for me. However, having done so I rediscovered my love of investing as a result.

What has been your biggest achievement at Saracen Fund Managers to date?

Launching the UK Income fund. Whilst it is currently very small, we are building up a great performance track record. My experience in running my own business has also allowed me to help improve Saracen in other ways, getting my hands dirty with systems and outsourcing amongst many things. In a small business there is no safety blanket and you have to turn your hand to all sorts of things.

What skills are necessary to make you succeed at your job?

Fund management is a job which offers great variety but also significant uncertainty of outcomes. It’s important to be aware of one’s faults and blindspots whilst retaining an open mind to opposing views. It is vital to have a focussed and consistent investment process which investors can understand clearly and an ability to ignore noise and distractions. Humility and a commitment to constant learning are also key qualities for any investor to have in my opinion.

What are the best and worst parts of your job?

The best part is seeing one’s best ideas come to fruition and delivering returns to our investors which are above their expectations. The worst part is dealing with the endless uncertainty that this quest brings and the inevitable failures that one will have along the way. It is impossible to avoid setbacks as an investor but ultimately the work requires you to get more things right than wrong on a consistent basis.

Where do you see yourself in 10 years?

Very much doing more of the same but hopefully with a higher profile and more investors on board. I’m not interested in being big for the sake of it or managing large teams of people. My colleagues and I are all committed to growing Saracen whilst remaining true to the investment philosophy and culture which we currently enjoy. Having all worked at larger businesses, we very much relish the challenges and freedom that being in a smaller business brings.

What role does technology play in your day to day working life?

It is becoming increasingly important especially within the context of being part of a small team. We have just upgraded to the Bloomberg data package which we hope will bring big productivity benefits to our research process. The next move is to become completely cloud based allowing us to work more effectively when we are out visiting clients and companies. I’m not a big fan of social media due to the extreme ‘noise’ aspect of it but I do follow some sage commentators on Twitter and LinkedIn.

What are your top tips for investment strategy for the coming year?

We have been wary of high bond prices for some time and this view is now beginning to come to fruition and we have very limited exposure to bond-sensitive investments in general. I am also wrestling with the conundrum between value and growth investment styles at the moment. It has been an exceptional period for growth investing in recent years and we are now seeing some significant value opportunities emerging in certain parts of the UK stockmarket.  At the moment no one seems interested in valuation. It is highly reminiscent of the way markets felt in late 1999. Value investing feels as out of favour as it was then and I think it could be due a comeback. This means I am likely to be wrong in the short term but overall I would rather be early than late if the margin for error today is suitably high.

What advice would you give someone starting out as a fund manager today?

Have an open mind, ignore noise wherever possible, read and learn as much as you can and try to find your own investment style. Ultimately to be a consistently successful investor one must do things differently from consensus.

Outside of work, tell us how you relax?

Walking our cocker spaniel is always a great diversion particularly on the rare occasions when it doesn’t rain in Glasgow!  I retain faint hopes of being a guitar hero and will torture the punters in my local from time to time with the odd tune. I will continue to play five a sides until injury or old age takes me but it’s fair to say that pace is no longer central to my game. My tennis could best be described as lightweight but enthusiastic with an emphasis on the social rather than the competitive.

 

Image result for glasgow pics

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Graham H Campbell gives an update on the latest activity within the TB Saracen Global Income & Growth Fund…

Fund Activity
JP Morgan Chase & GKN

JP Morgan Chase

The TB Saracen Global Income & Growth fund purchased JP Morgan Chase at $57.52 in February 2016.  It was a time of heightened equity market concern concentrated on the possibility of sliding into economic depression and the possibility of further bank bail-outs.  In short, with this negative sentiment reflected in valuations, it was a great time to invest!

Banks were still being described as ‘un-investable’ or ‘impossible to analyse’.  We agreed that banks were difficult to analyse, but not impossible!  We had watched JPM for some time and regarded it as one of the best placed global investment banks, with a strong US consumer business and with surplus capital above their regulatory requirements.  Based on our forecasts, if the shares were not cheap in February 2016, then we felt they would never be seen as attractive.

Our favourite investment scenario is when we are able to identify a global leading business and are able to acquire the shares at a fair price.  We purchased the shares on a forecast yield of around 3.3% and at a small premium to tangible book value.  As you can see from the above graph, the shares have performed well!

JPM is presently trading at more than twice tangible book value and the prospective dividend yield is now below 2%.  We typically expect to own shares in a business for much longer than this.  JP Morgan remains a good business, the US economy is still robust and management will deploy surplus capital into customer lending, dividends and share buy-back.  Nevertheless, at $112.8, we felt that this optimism was now reflected in the share price and we can find better value elsewhere in the sector.

GKN

We initiated a position in GKN in January 2013 for 247p.  The investment case was straightforward: GKN operates in the global aerospace and automotive markets:  Driveline (45% of profit) is a global leader in driveshafts, AWD and eDrives.  Aerospace (40% of profit) has a 75/25% commercial and military split, with number 2-3 positions in aero-structures, engine systems and electrical wiring.  Powder Metallurgy (15% of profit) is 80% automotive, selling both components and powders, where they occupy global number 1 or 2 positions.

In recent years GKN has exited most of its Land Systems businesses and expanded aerospace via merger and acquisitions, buying both the Volvo and Fokker businesses.

GKN was never a clean-cut investment proposition.  Investor returns were hampered by a large pension deficit that absorbed free-cash flow and persistently high capex requirements, leading to margins consistently below the targeted 10% level.  This was also exacerbated by two major problems that emerged towards the close of 2017, namely: – the CEO designate did not take up the position. He was scheduled to move from managing the Aerospace Division, but resigned along with the CFO as a result of the emergence of stock write-offs and warranty provisions.  These factors dented profits and the share price declined.

We were left with an investment that increasingly had all of the looks of a value-trap with poor earnings momentum.  Nevertheless, after a full review of our research, we decided that the shares still did not reflect the underlying business prospects and management would now be forced to consider all options to realise value.  In these circumstances, an investor frequently has to be patient.  Fortunately, this was not tested on this occasion and the approach by highly-regarded Melrose, pushed the share price sharply higher.  However, with the yield on the shares now around 2% and with a largely equity offer, we decided to sell at 440p.

Graham H Campbell, CEO and Co-Manager of the TB Saracen Global Income & Growth Fund

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December can be a useful time of year for fund managers to tear ourselves away from our screens, hit the road and spend some time with investors. David Keir and Graham Campbell, Co-Managers of the TB Saracen Global Income & Growth Fund, discuss client perspectives on life and the markets…

View from the road – December 2017

December can be a useful time of year for fund managers to tear ourselves away from our screens, hit the road and spend some time with investors.  It is always insightful to hear how our clients view life and markets; and some interesting perspectives came out.

  1. A number of clients asked about the dividend yield on the TB Saracen Global Income & Growth Fund and our allocation of charges to Capital and Income.
  2. Investors are getting increasingly nervous about the valuations in “bond proxies” and US growth stocks. Several clients questioned whether it is time to buy “value”?
  3. Retail investors are now asking about how to invest in Bitcoin.
  4. How will receipt of the TB Saracen Global Income & Growth Fund mailing list be affected by MIFID II? We have still yet to find a person that thinks MiFID II is a good idea!

 

  1. Dividend yield on the fund and charging structure

We have received feedback from a number of clients regarding the dividend yield on TB SGIG and our charging structure.

Whilst the forecast gross running yield on the fund for the next 12 months is 3.7%, the historic dividend yield is only 2.6%.  The difference between the historic and forecast yield is clearly the timing of receipt of dividends from companies and paying them out to investors and our annual management charge (‘AMC’).

Obviously, the lower yield is clearly a reflection on the fact that equity markets have done so well in recent years!

When we launched the fund, we decided to split the AMC 50% against income and 50% against capital, given that we were targeting growth in income and growth in capital over the long-term.

Our understanding is that we are the only fund in the Global Equity Income sector to do this as everyone else charges the AMC 100% against capital, to enable the payment of a higher dividend on the Income class of units.

The 2.6% historic yield is low for some of our income holders and they have asked us to change the charging structure to 100% against capital.

We have taken this feedback on board and decided to make the change which we expect take place in Q1 2018.

The change will boost income by between 40-50bps per annum which will bring the historic yield above 3%.

This will not have any impact on the way that we run the fund.

  1. Investors becoming wary of valuation in certain parts of the market

We got the sense investors are increasing nervous about holding onto their growth names (think US FANG stocks) given the absolute valuations compared to the value on offer in other parts of the market.

In addition, investors remain holders of the so-called bond proxies (through direct equities and in bond type equity funds) despite the valuation and limited growth on offer.  However, we sensed that clients are keen to switch into other parts of the market but to date haven’t had the confidence to do so.  We believe that sustained economic growth will encourage investors to make that switch.  Remember – consumers don’t buy more toothpaste when economies improve!

Maybe 2018 will be a better year for value…

  1. Bitcoin

We must be getting near the top in Bitcoin: the cryptocurrency, which started the year at around $1,000, and is now trading above $14,000.

Several clients mentioned that retail investors have been contacting them asking how they can invest in it.

However, we would remind our readers that Bitcoin is unregulated and not backed by any central bank.

  1. Regulation

With the deadline of 3 January 2018 fast approaching, most of our clients are incredibly busy preparing for the introduction of Mifid II.  In response to a couple of enquiries, we can confirm that   the receipt of our factsheets/quarterlies and blogs through SGIG mailing list is unaffected by MIFID II.

 

Many thanks for your continued support and we wish you all a very Merry Christmas and best wishes for a successful 2018!

 

David Keir (david@saracenfundmanagers.com)

Graham Campbell (graham@saracenfundmanagers.com)

Co-Managers, TB Saracen Global Income & Growth Fund

 

Important Information: The views and opinions contained herein are those of the author’s, and may not necessarily represent views expressed or reflected in other Saracen Fund Managers Ltd communications, strategies or funds. This material is an opinion piece and intended to be for information purposes only. This material is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The material is not intended to provide and should not be relied on for accounting, legal or tax advice, or investment recommendations. Reliance should not be placed on the views and information in this document when taking individual investment and/or strategic decisions. Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested. All investments involve risks including the risk of possible loss of principal. Information herein is believed to be reliable but Saracen Fund Managers Ltd does not warrant its completeness or accuracy. Reliance should not be placed on the views and information in this document when taking individual investment and/or strategic decisions. Some information quoted was obtained from external sources we consider to be reliable. No responsibility can be accepted for errors of fact obtained from third parties, and this data may change with market conditions. This does not exclude any duty or liability that Saracen Fund Managers Ltd has to its customers under any regulatory system. The data provider and issuer of the document shall have no liability in connection with the third-party data. The Prospectus and/or saracenfundmanagers.com contains additional disclaimers which apply to third party data. Regions/sectors shown for illustrative purposes only and should not be viewed as a recommendation to buy/sell. The opinions in this document include some forecasted views. We believe we are basing our expectations and beliefs on reasonable assumptions within the bounds of what we currently know. However, there is no guarantee than any forecasts or opinions will be realised. These views and opinions may change. Saracen Fund Managers Limited is Authorised and Regulated by the Financial Conduct Authority.

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Graham Campbell, CEO and Co-Manager of the TB Saracen Global Income & Growth Fund, drills down into his latest purchase for the fund…

Historically, some of our best decisions have come from investing in a global leading business, when many investors were obsessed with short-term concerns and the share price is depressed.  Providing the underlying industry position remains favourable, the company will recover strongly when sentiment in the sector improves.  Purchases of Microsoft, JP Morgan and Novo Nordisk were all made in the face of adverse short-term conditions and they have since rewarded investors handsomely.

Schlumberger is the leading provider of technology services to the oil and gas exploration sector.  It specialises in reservoir characterisation, drilling (bits, fluids, tools), production and processing technologies to the sector.  It operates in more than 85 countries, is active on over 3,000 drilling rigs and employs over 100,000.  It has always been regarded as a high quality, technological leader.  SLB invests over $1bn pa in R&D* (more than the combined investments of 3 closest competitors) and has a strong position in unconventional reservoir extraction. The steep decline in capex by the oil companies is unprecedented and unsustainable.

Over many years we have watched Schlumberger shares and met former management, yet the shares were never cheap enough and the yield was too low. The above chart highlights an almost 50% fall from the peak and while the short-term earnings multiples are high, we expect a rapid recovery in earnings over the next 5 years.

Schlumberger depends on activity from its customers and many have been squeezed by a sharp reduction in cash flow from weak oil and gas prices.  Industry statistics indicate that inventories are now broadly in balance and the oil price has recovered to over $60 Brent.  Nevertheless, many in the sector intend to keep a tight lid on capex in the short-term.

In response, the downturn has accelerated the consolidation of the oil service companies.  It will give them greater bargaining power when the upturn arrives.  It has also driven closer technological co-operation between the service/technology providers and the E&P companies.  In response, SLB has shared some of the cost burden on customers by widening Production, Drilling and Service ventures. However, these contracts that have significant upside performance elements.  The highest level of collaboration is in Schlumberger Production Management) SPM, where the company takes full responsibility for technology and performance.   Currently SPM manages 11 projects and produces around 235.000 bpd.

As ever, the biggest factor is timing.  While the global economic recovery appears sustainable and demand for oil and gas is expected to be positive, companies remain cautious about increasing capex to new programmes.  However, declines in production are inevitable without fresh drilling and investment can be delayed, but not avoided.

Despite the collapse in activity, operating margins for the SPM’s divisions are still above 10%, highlighting the quality of the business.  The dividend is not covered by earnings, but the balance sheet is robust with net debt (including pension liabilities)/EBITDA at only 1.8x) and management is committed to the pay-out.

Given our low confidence in being able to  time share price bottoms and tops, we have initiated with a 1.5% position in TB Saracen Global Income & Growth and will top-up into any price weakness.

*Schlumberger

Graham Campbell – CEO and Co-Manager of the TB Saracen Global Income & Growth Fund

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Graham H Campbell, Joint Manager of the TB Saracen Global Income & Growth Fund, on the pitfalls of compromising management credibility in the eyes of investors…

As investors, we are frequently searching for fragments of information that confirm or disprove our investment thesis.  It largely condenses into the following question: “Are management actions consistent with perceived strategy?”

Saracen Fund Managers has long been a supporter of Novartis.   Our investment case was based on the attractive pharmaceutical pipeline, growth in generic drug use and positive demographics surrounding eyecare.  The initial purchase into TB Saracen Global Income & Growth was attractive and we have achieved a return of over 60% in share price terms (plus dividends and currency) on our initial investment.

Novartis has more strategic issues than most.  For some time, management has considered selling off the Alcon eye-care business (decision now expected 1st Half 2019), it also has a minority position in OTC medicines with GSK and a shareholding in Roche, valued around $13bn.   These positions provide optionality.

In addition, while the company is not alone in stripping out some large and recurring costs, such as restructuring and legal expenses to their calculation of ‘Core’ earnings, the variance between both measures is considerable.  In turn, we do our best to re-adjust to reflect a more accurate measure of performance and future cash flows.  The company also enjoys a very low tax charge of around 15%.  Joe JIminez, the current Chief Executive, has decided to step down a year earlier than expected to make way for Vas Narasimham, the current Global Head of Drug Development.

It has been a good few years since I read “Barbarians at the Gate: The fall of RJR Nabisco” by Bryan Burrough and John Helyar.  I remember being amazed by the corporate excesses of the times and in particular the 10 private jets that formed the RJR Air Force!  I assumed these days were long gone and vanity projects of this type were now solely the indulgences of private ventures by billionaires and oligarchs.

While there has been more focus by management on improving the manufacturing and technology platforms of the business, it would appear that it has not been equally applied to all operations.  Page 247 of Novartis’s Annual Report 2016 has the following disclosures for ownership of Spanish business.  The pertinent entry is the final one: Abadia Retuerta (The hotel is pictured above).

Spain Share /
paid-in capital
Equity
interest %
Novartis Farmaceutica S.A. Barcelona EUR 63.0m 100
Alcon Cusi S.A., El Masnou / Barcelona EUR 11.6m 100
Sandox Farmaceutica S.A., Aravaca / Madrid EUR 270,450 100
Sandoz Industrial Products S.A.,
       Les Franqueses del Valles / Barcelona EUR 9.3m 100
Abadia Retuerta S.A., Sardon de Duero / Valladolid EUR 6.0m 100

 

Further information on the business can be found on the Abadia Retuerta website and a review from The Telegraph

In summary, there are considerable strategic uncertainties facing Novartis at a time where underlying operating performance has been disappointing.  The valuation is firmly in Hold territory on our ‘clean’ numbers.  The ownership and investment in non-core assets such as a luxury hotel and winery, may not appear significant from a business the size of Novartis, which has revenues of around $49bn.  Nevertheless, it dents management credibility and our confidence that management is sufficiently aligned with all shareholders.  When the incoming CEO manages to re-assess the strategy, all may become clear and our concerns will dissipate.  However, the team here invest with conviction and frankly, we don’t feel that conviction with Novartis at present. We have Sold the shares and reinvested the proceeds elsewhere in the sector.

 

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