In June, the Global Franchise Portfolio returned -0.27%, underperforming the MSCI World Index which returned 1.79%. In the second quarter, the Portfolio returned 4.73%, marginally underperforming the Index which returned 4.86%. Year to date the Portfolio has returned 5.54% versus 6.18% for the Index.
The underperformance in June was due to the large overweight in consumer staples, aggravated by stock selection in consumer staples and information technology. Looking at the second quarter, the underperformance was slight in a strong market. The zero weight in energy was a drag, partly mitigated by the underweight in financials. In terms of stock selection, information technology was a drag, but consumer staples, consumer discretionary, and financials were positives.
Top absolute contributors for the quarter were British American Tobacco (LSE:BATS)(9.7% of the portfolio), Nestle (XSWX:NESN)(9.2%) and Unilever (LSE:ULVR)(8.1%). The top absolute detractors for the quarter were SAP (XTER:SAP)(4.1%), Visa (V)(3.3%) and Experian (LSE:EXPN)(1.6%).
The global equity markets, as measured by the MSCI World Index, had a decent quarter, returning 4.9% (4.4% in local currency). The market rise was pretty broad-based, both in terms of geographies and sectors. Canada (9.9%) and UK (6.1%) were both helped by strengthening currencies, while Japan (6.7%) clawed back its first quarter losses. The U.S. (5.1%) was roughly in-line with the overall index, but the ‘core’ Euro area was weaker, with Germany ‘only’ 1.7%, France 1.7% and the Netherlands 0.5%. The Euro-periphery fell back a bit after a euphoric first quarter, with Ireland -9.0%, Portugal -2.6% and Italy -0.1%, though Spain (7.2%) significantly outperformed both its peers and its own football team.
On a sector basis, energy and utilities led the way. Information technology, consumer staples, healthcare and materials were all close to the market as a whole, while telecommunications, consumer discretionary, industrials and financials were mild laggards.
During the quarter we initiated a position in Publicis (1.0%), and exited the last of our position in Admiral. We added further to the recently initiated position in Time Warner (TWX)(3.6%), partly funded by selling a small position in Time Inc. (TIME), the magazine business spun off from the parent. We also added to and reduced select Consumer Staples, Information Technology, Industrial and Financials names.
Publicis (XPAR:PUB) is one of the world’s leading global advertising services companies. We believe it is the most forward thinking of the large advertising players in the way it has positioned itself for the digital age. Unlike peers, the company balance sheet is run with low financial leverage and the return on investment in acquisitions is closely monitored. This focus on unlevered returns is likely to be because of the strong influence of Chairman Elizabeth Badinter, owner and daughter of the founder. Whilst it is a little cyclical, the high focus on return on operating capital, together with its leading strategic positioning, make this business attractive, as is the valuation, with the company trading on a free cash flow yield of over 8%.
The team became more wary of Admiral (LSE:ADM) after the 2011 turbulence in the stock price, after a scare about the potential for large personal injury claims. While the 2011 claims ratio eventually turned out to be fine, it caused a revision in our view of the quality of the name. The combination of the stock’s recovery, and long-term concerns about the effect of autonomous driving on the motor insurance industry, caused us to reduce and then exit the position.
Five years of central bank action have contributed to a world of high valuations across asset classes. In the equity world, bears point to the elevated CAPE ratio (cyclically adjusted price-to- earnings (P/E), calculated on the last 10 years inflation-adjusted earnings, also known as the Shiller P/E) and the related high level of corporate profitability. The current levels of the CAPE ratio in the U.S. (currently at 26 times, versus the long-run average of 16 times3) have historically been associated with low medium to long term returns, while corporate profits’ share of gross domestic product (GDP) has mean reverted in the past. Bulls suggest that corporate profits can remain strong, as labor’s bargaining power and government’s taxing power are both structurally impaired, and that valuations look reasonable, if you just compare them to the post-1990, post-Cold War world.
We remain nervous about the equity rerating that has occurred since late 2011, adding 60% to the MSCI World Index3, with no increase in prospective earnings, just as we are cautious about the prospective returns on bonds, starting from such low yields. Nevertheless, it is quite possible that both asset classes do fine for a while yet – after all, the equity market was arguably overvalued as early as 1996. While we are unclear about the direction for the market as a whole, we are clear in our belief that high quality equities, for a couple of notable reasons, are a refuge in a world where decent prospective returns are tough to find.
The first point in favor of high quality equities is that we believe their earnings should continue to compound over the long- term. The combination of sustained high unlevered returns on capital, steady moderate top-line growth, robust margins helped by pricing power and (last but not least) managements who look to the long-term, could potentially deliver steady earnings growth. The Global Franchise strategy has delivered compound earnings growth of 13% over the last decade2 (with dividends reinvested), and continuing to perform at anything close to that level over the next decade could generate decent overall returns. Importantly, earnings from high quality companies have proven relatively robust during shocks, which should help avoid the double-whammy of a simultaneous fall in earnings and valuation multiple that so effectively destroys capital. By contrast, we are worried about the less resilient margin structure underpinning the more cyclical companies which we don’t own in the portfolio.
The second point behind our preference for what we view are high quality equities is that you don’t actually have to pay much, if anything, for quality in current markets. The Global Franchise Portfolio offers three times the MSCI World Index’s pre-tax return on operational capital (58% versus 18%), twice the Gross Margin (52% versus 26%) and less than half the financial leverage (0.7x versus 1.5x).3 To get this, you only have to pay an 8% premium on the next twelve months earnings (16.2x versus 14.9x), while Global Franchise is actually cheaper on our preferred measure of prospective free cash flow yield (6.0% versus 5.1% for the Index) and has a higher dividend yield (3.3% versus 2.6%), as the capital-light model means that potentially more of the earnings turn into cash.
One strange anomaly is comparing the equity and bonds of high quality companies. Taking Global Franchise’s five largest holdings (Nestle, British American Tobacco, Reckitt Benckiser (7.0%), Sanofi (5.5%), and Unilever) as a proxy for high quality equities, the simple average of their trailing dividend yields was 3.4%. These dividends are all comfortably covered by free cash flow, helped by the capital-light business models, and a continuation of the historical compounding could drive steady growth in the pay-outs. By contrast, coupons on the bonds are fixed, and offer a yield of 2.1% over 5 years and 3.4% over 10 years4 (all in U.S. dollar). Even over 10 years, the fixed coupon only matches the trailing dividend yield, while any sort of compounding could drive both rising dividend pay-outs and capital appreciation over the next decade.
It is true that a dividend is riskier than a bond coupon, and there is uncertainty about the ‘terminal’ valuation of the equity holding in 10 years – after all, as one legendary analyst puts it, “equity is the thin slither of hope between assets and liabilities”. However, we would argue that in the case of the highest quality companies, like the five names above, the slither of hope is significant, given the steady top-line, low operational leverage and limited financial leverage.
Ultimately, on the risk-spectrum of ‘normal’ equities, ‘high quality’ equities and bonds, the valuations suggest that the market is discounting high quality equities fairly close to normal equities, when in fact their underlying economics suggest that they should be treated more like bonds, with the advantage that the high quality companies’ pricing power helps protect against inflation. It is possible that the market may see the light at some point, and rerate high quality equities relative to the market as a whole. While that would be welcome, it is not our basis for investing in what we consider high quality: we are simply relying on our companies continuing to compound better than the market over the long-term.
The arguments above are all relative, suggesting that high- quality equities look attractive versus both the equity market and fixed income markets. We would also claim that quality equities look fine in absolute terms. A prospective free cash-flow yield of 6.0% and cash return of a 3.4% dividend yield with some buy-backs on top does not look demanding for a portfolio of compounders – providing they continue to compound. Our efforts as ever, are concentrated on making sure they do.