Mawer New Canada Fund Investment Newsletter Q2 2013
Despite this mid-quarter swoon, global equity markets, as measured by the MSCI World Index (C$) posted a 4.4% gain. The chart below illustrates the quarterly performance, expressed in Canadian dollars, of some notable equity indices from around the world:
During this past quarter the relative strength in U.S. markets continued to be apparent as the 6.5% gain in the S&P 500 Index (C$) signiﬁcantly outpaced the returns of most other regions.
Canada's S&P/TSX Composite lost 4.1%, with plunging gold prices leading to a 22.8% loss in the Materials sector. Weakness in commodity markets was signiﬁcantly detrimental to Canada's small cap benchmark, with the 7.6% loss in the BMO Nesbitt Burns Small Cap Index largely attributed to the 26.3% free-fall in small cap Materials companies.
Europe avoided starring in any new major economic headlines but remains mired in a long and arduous process to address their ﬁscal imbalances. Nonetheless, the MSCI Europe Index (C$) rose 3.4%, with Germany's DAX Index (C$) posting a strong gain of 7.3%.
Moving East, Japan's stock market experienced one of the most volatile and remarkable quarters in recent memory. As noted last quarter, Prime Minister Abe has embarked on a mission to ﬁnally end Japan's long deﬂationary decline and spur the country towards growth. The magnitude of the stimulus efforts, coupled with proposals for much needed structural reforms, seemed to spark investor euphoria as Japan's long suffering Nikkei 225 Index soared over 25% in just a few short weeks. Several weeks later it had abruptly shed a large percentage of this gain. The Yen was equally as volatile, rapidly depreciating relative to most major currencies before regaining some value late in the quarter. The degree of volatility in Japan's equity and currency markets may reﬂect the inability of investors to understand the long-term implications of the government's aggressive economic intervention.
In the U.S., Bernanke's warning that quantitative easing could wane did not merely sway equity markets, but it had a signiﬁcant impact on ﬁxed income markets as well. Speculation leading up to his comments on tapering prompted the yield on the 10-year U.S. Treasury to rise from approximately 1.6% to 2.6%, before settling at 2.5% at the end of June. The reaction in Canadian ﬁxed income markets mirrored that of our U.S. neighbours with the DEX Universe Bond Index shedding 2.4%. This marks the worst quarterly return in Canadian bond markets since the mid-1990s.
HOW DID WE DO?
As active managers, our portfolios look different than the indices, and thus, can perform in a dramatically different manner. There is no better example of this during the quarter than our performance in Canadian equities.
On the surface, the 4.1% loss in the S&P/TSX Composite Index and 7.6% decline in the BMO Nesbitt Burns Small Cap Index this quarter may seem worrisome to Canadian investors. But upon closer inspection, it's clear that the primary culprit for these declines was the dismal performance of Canadian companies in the Materials sector. This includes gold companies and other ﬁrms related to metals, mining, forestry, and other raw materials.
The Materials sector represents approximately 13% of the large cap S&P/TSX Composite Index. These companies lost 22.8% on average during the quarter. Mawer's Canadian Equity strategy owns just one company in this sector, PotashCorp of Saskatchewan, which amounts to less than 2% of the portfolio.
PotashCorp (POT) delivered a modest gain of about 1% during the quarter — drastically better than having 13% of the portfolio lose over 22%.
The small cap story is even more remarkable. The Materials sector accounts for approximately 26% of the BMO Nesbitt Burns Small Cap Index. On average, this sub-section of companies lost over 26% this quarter, with plunging gold prices weighing heavily on many of these ﬁrms. Mawer did have over 9% of our small cap Canadian portfolio in the Materials sector, but our investments did not lose 26%, they gained approximately 13%. In fact, one of the bestperforming securities in the portfolio was Stella-Jones, which gained almost 30% in the last three months. Although Stella-Jones is technically a component of the Materials sector, it does not mine for gold or other metals. Based in Quebec, Stella-Jones supplies a large portion of North America with wood products, such as railway ties and telephone poles.
Not every decision in the portfolio worked in our favour this quarter. Japanese equities are scarcely represented in our portfolios, especially compared to international equity benchmarks where Japan is a sizeable component. As noted earlier, Japanese authorities have embarked on monumental and potentially game-changing initiatives to revive their economy. By mid-May, Japan's Nikkei 225 Index had soared over 25% on the quarter, leaving our international equity portfolios considerably behind the index. Though Japanese markets soon corrected and erased much of these gains, they still ended the period with gains of over 8% (C$), signiﬁcantly outpacing other regions. On a relative basis, our international equity portfolios suffered from this positioning.
Our decision to underweight Japan was not the result of top-down analysis or ranking of countries; rather, it was a byproduct of following our philosophy. We have been scouring Japan for opportunities but rarely find companies that satisfy our criteria. Our most challenging hurdle has been our emphasis on ﬁnding companies led by high-quality management teams. It would be unfair to label Japanese managers as being unskilled or mediocre – many are exceptionally capable and trustworthy individuals – but they often adhere to priorities that can be harmful to shareholders. Paul Moroz, Mawer's Global Equity Manager, spent a week in Japan this quarter to meet with 21 companies and 10 investment analysts. When he returned, he shared an example of a management team that was very candid about their goal to create a certain amount of jobs in the region. While this desire to achieve certain socio-economic goals is commendable, it can be counter-productive to shareholders. Will they keep an unproﬁtable subsidiary aﬂ oat just to keep jobs? Will they deploy capital to low-return opportunities as opposed to returning capital to shareholders?
For now, our portfolios continue to have minimal exposure to Japan. This has been beneﬁcial in the past, as the chart below illustrates how poorly Japanese equities have performed throughout the last 25 years, but this positioning was certainly detrimental this quarter. If this latest Japanese resurgence is sustainable, our relative returns may suffer.
For several quarters we have made reference to the risk of rising interest rates, and although central banks did not actually raise administered rates, a signiﬁcant rise in bond yields did come to fruition. Recognizing that higher interest rates can be harmful to bonds and equities, our quest to build greater portfolio resilience to rising rates requires a multi-faceted solution to our bond, equity, and asset allocation decisions.
Within bonds, one tactic we had previously employed to mitigate the risk of rising interest rates was to allocate approximately 15% of the portfolio to Floating Rate Notes. Since the price of Floating Rate Notes do not decrease when bond yields rise, this portion of our portfolio preserved capital better than conventional bonds this quarter. While this alone was not enough to offset the broader weakness in Canadian bonds, this positioning did protect the portfolio from more signiﬁcant declines.
Within equities, we believe that most companies will be negatively impacted by rising interest rates, but we did identify some exceptions. For example, the CME Group is a Chicago-based operator of numerous trading exchanges including a large volume of ﬁxed income futures contracts. Higher interest rates and greater interest rate volatility tends to be a catalyst for greater trading volumes, and hence, greater revenue for CME (CME). The company was our top-performing U.S. investment in the last three months with gains of nearly 30%. The insurance industry is another area that we believe can offer resilience in the face of rising rates. This quarter we added to our positions in Manulife Financial in Canada, AmTrust Financial in the U.S., and introduced U.K.-based Aon to our international portfolio. Many of our insurance companies enjoyed strong performance this quarter and helped offset the declines suffered within the ﬁxed income portfolio.
Building resilience to rising interest rates also took place at the asset mix level. For several years, we have maintained a relatively low weight in ﬁxed income, the lowest in Mawer's 39-year history. As an offset, we have recommended a larger allocation to short-term money market securities. While this defensive positioning was not rewarded in recent quarters as bonds have delivered superior returns relative to those of money market, this strategy did protect portfolios from larger declines this quarter.
Two of the more recognizable additions to our portfolios in the last three months were BMW and Louis Vuitton.
Most readers know BMW as a luxury auto manufacturer, but they also operate a sizeable ﬁnancing and leasing division. Interestingly, when these two core businesses are viewed together, many of the traditional ﬁnancial ratios look somewhat ordinary.
Therefore, at a cursory glance, BMW did not seem that appealing. But when we viewed the metrics on the two business segments separately, we found them both to be quite attractive.
The next phase in our due diligence process highlights the cultural and linguistic diversity that we have developed over the years. We now have members of our team that are ﬂuent in seven different languages, many having lived, studied, or worked abroad. Before joining Mawer as an Equity Analyst, Christian Deckart spent 15 years working in Europe. His ﬂuency in German and familiarity with the German business environment was beneﬁcial as we sought greater knowledge about the company's strengths, weaknesses, opportunities, and threats.
Christian arranged a visit to BMW (XTER:BMW) headquarters in Munich, including a tour of the factory ﬂoor to witness the manufacturing process in action. This exercise alleviated some concerns about higher German labour costs as Christian reported that approximately 90% of the manufacturing process in the BMW plant is automated. He watched the automation shift from a luxury sedan to a hatchback without interruption; a truly impressive display of German engineering. We believe BMW will deliver attractive returns over time, and it offers exposure to higher growth emerging markets within the politically stable conﬁnes of Germany.
Louis Vuitton (LVMH) is one of the world's leading manufacturers and retailers of luxury apparel. Nearly two years ago, we began to analyze the company. We liked the business model, particularly the growth potential as consumers in emerging markets grow more eager to demonstrate their afﬂuence. We concluded that the company was well-run by a trustworthy management team, but its valuation did not seem very compelling. Louis Vuitton did not appear to be trading at what we felt was enough of a discount to its intrinsic value. Despite this, we did not abandon the idea. For the next 18 months we kept Louis Vuitton on what we call our inventory list. It was an investment we were comfortable making if the right price presented itself. In April, Louis Vuitton shares declined sharply after shareholders were disappointed by their latest earnings announcement, bringing the stock down to a valuation that we felt was attractive. We acted quickly to purchase shares.
Louis Vuitton was one of the better-performing companies in our portfolio since its introduction in April, with returns of approximately 7% thus far. It is an example of patience being rewarded and something we hope to replicate with the many other companies on our inventory list.
We have disappointing news for those readers hoping to exercise this same level of patience and purchase their favourite Louis Vuitton handbag on sale. One of the more interesting things we learned about the company is how driven they are to uphold their brand image as the pinnacle of high-end luxury. Selling last season's model in the 50% discount bin may seem like a logical way to convert excess inventory into revenue, but management at Louis Vuitton worry that this can tarnish brand image. Instead, they opt to destroy surplus inventory to protect the brand. So if you have your eye on a certain item, you may want to buy it before the end of the season.
Looking forward, we expect the theme of rising bond yields and interest rates to remain in the forefront. We feel comfortable in how we have positioned our portfolios should this scenario unfold.
In our view, a slowdown or more serious ﬁnancial crisis in China presents a more worrisome risk. We believe resource-rich countries like Canada, Australia, Brazil, and South Africa would be particularly vulnerable to a slowdown in China, including the depreciation of their currencies. To address this risk and build greater resilience should this scenario unfold, we have been reducing exposure to companies located in several resource-rich countries. We expect this trend to continue heading into the next quarter. We are primarily using the proceeds of these sales to increase our exposure to U.S. equities where we deem the economic recovery is more advanced.
We believe that investing in less liquid companies can be rewarding, but we also recognize that these investments may be particularly susceptible should a severe global slowdown unfold. This was something we observed during the recession in 2008. To mitigate this liquidity risk, we have been reducing our exposure to less liquid companies this quarter, and reinvesting the proceeds into investments that are more frequently traded.
Our asset allocation committee continues to recommend a slightly higher than neutral allocation to equities, with higher than normal levels of short-term reserves offsetting a relatively low allocation to bonds. With that said, we did recently take advantage of the weakness in bond markets to deploy a small amount of short-term reserves back into bonds. Should weakness persist and yields rise further, we may continue to unwind our defensive positioning and restore a larger allocation to bonds.
The second quarter of 2013 was an exciting time for us at Mawer as we added to our family of funds with the launch of the Mawer Global Balanced Fund. The Global Balanced Fund differs from most balanced portfolios in that risk is managed on a bottom up or "brick by brick" basis without the conﬁnes of traditional geographical constraints. Risk is further managed through extensive diversiﬁcation across many industries and countries, coupled with the use of investment grade Canadian bonds.
Mawer also announced that it is expanding its global presence to include a location in Singapore as of August 2013. Peter Lampert, an international equity analyst who has been with the Firm for ﬁ ve years, will be relocating from Mawer's Calgary location to Singapore. While Mawer has been investing successfully on a global basis for over 30 years, the Firm believes this endeavor will meaningfully enhance its ability to do so by providing a much greater understanding of the Asian region in general. It will also enable more direct access to companies for research, monitoring and meeting purposes, and allow the Firm to have 24-hour coverage of global events.
In other news, Michael Rabinowitz, a fourth year student from Western University's Richard Ivey School of Business, was selected as the winner of Mawer's third annual Research Report Challenge. As the winner, Michael will receive a cash prize and the opportunity to spend a day with the Mawer Research Team.
For more details on any items in the Mawer Notes section, please visit mawer.com.