May 4, 2016
Dear Shareholder:
The post-Bretton Woods monetary system, in place since 1971, entered a new chapter few ever envisioned: the era of long-term negative interest rates is upon us. In Japan and Switzerland, 10-year government bonds currently yield less than zero to maturity. Nobody knows how the book ends. Given the perverse incentives induced by these policies, the script is more likely to be turned into a horror movie than a Disney blockbuster, we believe. Only time will tell though. These aggressive policies by central bankers in the developed world, far from enticing companies to invest and add productive capacity, send an ignominious signal: all is not well. Far from stirring consumption, such low rates force consumers to save more for the future. Instead of helping companies deleverage, these policies subsidize poorly managed corporations, steering zombie companies away from bankruptcy. What these policies have achieved though, is to inflate values in almost all asset classes.
Despite the recent efforts to normalize interest rates (the U.S. Federal Reserve hiked short term interest rates for the first time in ten years in December 2015), the financial environment remains highly accommodative, more than seven years after the global financial system nearly collapsed. The economic cycle in the U.S. is now fairly advanced: U.S. vehicle sales are near a record, and U.S. unemployment is at low levels. The U.S. financial system is, in our opinion, now well capitalized, a great achievement, in sharp contrast to the situation that prevailed in 2008. Credit growth in the developed world has been tepid to non-existent since 2009, hopefully preventing the formation of major systemic bubbles. In emerging markets however, credit growth has been massive, led by China. Brazil is already well into its credit bubble aftermath. China remains in denial and seems to be fighting gravity: the state-controlled corporate sector shows poor profitability, high debt and has to contend with rapidly rising labor costs, while the Chinese currency remains pegged for now to a basket of currencies.
The combination of nosebleed valuations, a well advanced economic cycle in the US, unsustainably high profitability by many listed corporations in the developed world, and extremely low, manipulated interest rates are the reasons why we remain cautiously positioned, with roughly 50% in equities and 40% in cash in both Funds. (gold bullion and high yield bonds account for the remainder.)
Our primary mandate is preservation of capital. Over time we want to do better than equity benchmarks. Because cash (invested in short-term commercial paper of our choosing) yields very little, many investors are pushed into risky asset classes at the wrong time. We refuse to succumb to the sirens. Our roughly 50% in equities is the result of carefully selecting securities that traded at reasonable discounts to our estimate of their intrinsic values at the time of our investment. (We define intrinsic value as the amount a knowledgeable investor would pay in cash, for the whole company.) We insist on good balance sheets, so that, if our assessment turns out to be inaccurate, the downside will hopefully be limited; we are willing to accept lower discounts for better businesses, and for good capital allocation by management. We demand much larger discounts for more average businesses and for less than stellar capital allocation.
Both Funds have an allocation to gold bullion to provide a hedge against extreme outcomes. The Greek population (who suffered through devastating deflation in the recent years) and the Venezuelans (who went through hyperinflation) both recently witnessed how gold offered protection and relative stability as an investment in the worst possible investment environments. Gold acted as expected during the first six weeks of 2016: as financial markets tanked under a deflationary scare, gold went up, offering some offset to paper losses on equities in your Funds.
The cash in your Funds will be deployed when bargains show up. Far from burning a hole in the Funds’ pockets, we believe cash has meaningful optionality value and will be the dry powder used to pounce when prices get attractive enough.
A few sectors and geographies are currently in a state of flux, upheaval or recession, yet finding bargains there remains a challenge:
- Brazil is going through its worst recession in decades, after politicians squandered the spoils of a commodity boom driven by the Chinese economic growth. While earnings in Brazil are arguably depressed, valuation multiples are not. Moreover, the Brazilian real (the local currency), is expensive to hedge, and has not yet devalued to a level that would make Corporate Brazil highly competitive in global trade.
- The Chinese economy is also currently experiencing a slowdown, if not worse. As a result, a number of Hong Kong listed securities appear to be trading either at low multiples of earnings, or low multiples of stated net asset value. In sharp contrast to the Asian Crisis of the late 90’s, this time markets are ‘aware’ of the Chinese risk and are applying sometimes heavy discounts to headline numbers. We remain wary of these situations however, as China seems to have gone through a classic credit bubble: heavy credit growth since 2008, such credit allocated perhaps not on business merits, but on political connections. The main culprits of credit excesses appear to be Chinese State Owned Enterprises (SOEs), where loans may have been granted regardless of the ability to repay. Given the size of the Chinese economy today, this remains, in our opinion, the largest threat to the world economy.
- Oil and gas, and commodities in general, have suffered devastating blows from overcapacity coming on line at the same time the Chinese economy slowed down. While oil and gas exploration and production companies have derated substantially, we believe most continue to discount USD 60 per barrel or more for oil prices, versus a spot market closer to USD 45 per barrel of oil. The U.S. shale oil revolution has unlocked tremendous new supply that may hit the market well below USD 60 per barrel. And low interest rates have delayed necessary bankruptcies in the industry. We have been able to buy a couple distressed bonds of equipment providers for the mining industry (Joy Global Inc. for the Worldwide Fund) and some bonds backed by oil rigs or helicopters (Rowan Cos., Inc. for both Funds, and Era Group Inc. for the Worldwide Fund).
- Lastly, financials, more specifically banks, come to mind: in developed economies and in China, many banks are trading at low multiples of book value by historical standards. Chinese banks are un-investable for us today given the opacity of their loan books and our belief that credit has been overextended in China. In recent weeks however, we made two new investments in financials in the U.S. for the Worldwide Fund (we disclosed the investment in Bank of America Corp. in this report). The key question today on financials in the U.S. is not one of solvency in an economic downturn; the difficulty lies in assessing the return on equity of such institutions over a cycle under the new regime of overregulation and high capital requirements. We suspect such return on equity over a full economic cycle will be adequate, but far from stellar, for many financial institutions in America. While we believe U.S. banks and the U.S. financial system as a whole are well capitalized, we have doubts about many European banks. They often remain undercapitalized and the regulations in Europe carry what we believe to be a substantial flaw: all government bonds are considered free of default risk. However, Greek, Italian, Portuguese, Spanish or French government bonds all carry the risk of a political earthquake: the election of a party advocating an exit from the currency union. Will Great Britain show the path in its upcoming referendum on EU membership?
Despite this challenging environment, our investment team has been able to unearth some gems over the last few years. Among our top 10 holdings in both Funds, we own well capitalized, and for the most part well managed companies. A number of those went up in price since we first bought them, and therefore, the discounts may not be as attractive as they once were. If they remain properly managed and capital allocation as well as governance are of high quality (Nestlé SA comes to mind), we may be willing to hold (not buy, simply hold) such securities closer to intrinsic value. Some still offer large discounts in our opinion (Samsung Electronics Co., Ltd., Hyundai Mobis, Co., Ltd. come to mind), albeit both groups suffer from questionable corporate governance. Both are low cost producers and enjoy what we believe are sustainable competitive advantages (scale and R&D for Samsung; scale and heavy plant automation for Hyundai Motors, partly owned by Hyundai Mobis). Whilst we have had to reduce our intrinsic value estimates on two names, News Corp. (NWSA, Financial) and DeVry Education Group Inc. (DV, Financial), both came down a lot in price and thus currently trade at a sizable discount to what we think they are worth. News Corp.’s value has been impaired by a continued difficult environment for their newspapers, a weaker Australian dollar and the expensive acquisitions of Move Inc. and iProperty Group Ltd. A substantial part of News Corp.’s value though resides in their ownership of a stake in REA Group Ltd, a dominant and highly profitable real estate portal in Australia. As for DeVry (which only the Worldwide Fund owns), our intrinsic value estimate was impaired as we underestimated the extent of the decline of the BTM (Business, Technology, Management) segment. We note, however, that the overwhelming majority of DeVry’s profits come from its healthcare schools (Nursing, Veterinary, and Physicians) where student loan defaults have been negligible.
Finally, a word on Astellas Pharma Inc. (TSE:4503, Financial), owned by both Funds. Astellas is the perfect antithesis of Valeant: Astellas spends substantial amounts on R&D (around 17% of revenues) and develops life-saving drugs, recently in oncology with Xtandi (treatment of prostate cancer); has no financial leverage; does not engage in price gouging; has a strong pipeline and conservative accounting; allocates capital well; pays dividends; buys back shares at reasonable prices whilst maintaining a substantial net cash position: exercises restraint in compensation of senior executives; is not promotional; and trades at a single digit multiple of earnings before interest, amortization and taxes. One risk, however, is that high healthcare costs in the U.S. lead to greater regulation of drug prices in the U.S. Such a development would be a negative for Astellas. We believe that risk is more than priced in at the current stock price.
We continue to search the world for opportunities, with a focus on controlling risk: reasonable position sizes, good balance sheets, and acceptable discounts at time of investment are three key pillars of risk mitigation.
We appreciate your continued confidence and thank you for your support.
Charles de Vaulx (Trades, Portfolio), Chief Investment Officer and Portfolio Manager
Charles de Lardemelle, Portfolio Manager
