Performance Review
In March, the Global Franchise Portfolio returned 0.53%, outperforming the MSCI World Index, which returned 0.14%. For the first quarter, the Portfolio returned 0.77% and the Index returned 1.26%.
The Portfolio’s underperformance for the quarter was mainly due to stock selection and an underweight in health care. Stock selection in information technology and having no holdings in the utilities, materials and energy sectors also detracted from performance. This was partly offset by positive stock selection in consumer staples, underweights and stock selection in the consumer discretionary and financials sectors, and a zero weight in telecommunication services.
Top absolute contributors for the quarter were British American Tobacco (LSE:BATS)(9.7% of the Portfolio), Microsoft (MSFT)(3.9%) and Unilever (LSE:ULVR)(8.0%). Top absolute detractors from performance for the quarter were Herbalife (HLF)(0%), SAP (XTER:SAP)(4.6%) and Diageo (LSE:DGE)(4.8%).
Market Review
Despite much sound and fury, equity returns ended the first quarter materially unchanged. The MSCI World Index rose 1.26%. Even the MSCI Emerging Market Index was virtually unchanged (-0.43%), despite another negative investor reaction to the Federal Reserve’s plans to taper its asset purchases at the beginning of the year.
On a regional basis, Europe finished the quarter higher, led by the Nordic region. The U.S. performed broadly in line with the MSCI World Index. The Pacific region fell, with Japan the clear laggard as Japanese stocks suffered from some profit taking after last year’s strong performance and amid increasing disillusionment with Prime Minister Abe’s economic policies.
On a sector basis, utilities was the standout sector, followed by health care. Information technology, materials and energy all rose, also outperforming the Index. Financials, consumer staples, industrials and telecommunications all underperformed, while consumer discretionary was the clear laggard for the quarter.
Portfolio Activity
During the quarter, we initiated a position in Time Warner (TWC)(3.0%), which is one of the largest U.S. cable network businesses and parent company of Warner Brothers film and TV studios. Time Warner networks include CNN, HBO and Turner Networks. Return on operating capital at the cable networks is currently over 50% and closer to 15% at the film studios.1 We believe Time Warner is one of the best run cable network businesses in North America as it offers almost pure exposure to high return businesses where other networks companies often do not. The company is the leader in original scripted content in North America and also has a leading film franchise. It has an extensive film library and is able to monetize its content not just in the U.S., but globally. The stock is trading on a free cash flow yield of about 7%, with free cash flow expected to grow over 6% per year for several years to come.
We sold the Portfolio’s positions in Dr. Pepper Snapple (DPS)(for valuation reasons) and Herbalife (HLF). We had been opportunistically reducing the Portfolio’s Herbalife position over the last six months as the stock became more volatile due to regulatory risks. With these risks recently escalating, the team decided to exit the position completely. We also adjusted exposure (adding to some positions and reducing others) to select consumer staples, consumer discretionary and financials stocks during the period.
Outlook
Emerging market exposure appears to have turned from a virtue to a vice, driven by a change in the global interest rate environment, disappointing expectations for China’s gross domestic product (GDP) growth and mounting political and fiscal concerns in Eastern Europe. Because the Portfolio generates approximately one-third of its revenues from its indirect exposure to emerging markets and, in aggregate, the majority stems from consumer staples holdings, it is appropriate for us to comment on why this exposure remains important. Keep in mind that we believe investing in well managed, high quality global companies, which we identify as those with pricing power, high returns on operating capital and strong, resilient free cash flows in developed markets has been, and should remain, an excellent source of successful compounding.
The long-term prospects for high quality businesses exposed to both emerging market consumers and expected rising disposable incomes in emerging markets are compelling, not only due to potential revenue growth, but also for potential margin expansion, as expressed by Paul Polman, CEO of Unilever.
“We believe Unilever’s margin opportunity remains large, especially in emerging markets which we see as a huge opportunity. We should continue to see margin growth in our emerging market business as it continues to gain critical mass, including markets such as Russia and China. By the end of this decade, emerging markets will contribute 70% to our business.”(57% as of March 31, 2014)
We expect more consumption and “up-trading” of consumer staples products, and it is striking that valuations on this most economically insensitive sector have declined compared to the MSCI World Index, and particularly compared to the more economically sensitive sectors such as global industrials. Industrials generally have significant operating leverage and a relative lack of pricing power, as well as meaningful dependence on GDP growth, capital expenditure and trade flows. Since May 2013, the MSCI World Consumer Staples Index has been flat, while the MSCI World Industrials Index has risen 12%.
Have emerging market consumer staples become a source of value following recent market activity? No. We believe they remain expensive. The weighted average next 12 months (NTM) price-to-earnings (P/E) for emerging market equities as a whole is 15x, with a Price to Free Cash Flow (NTM) of 23x. By comparison, emerging market consumer staples stocks are trading at an elevated 22.5x P/E and 27x Price to Free Cash Flow.
So it seems emerging market investors are hiding in expensive emerging market consumer staples stocks, while global investors are betting on increasingly expensive industrials stocks. As always, our focus remains on high quality companies that we believe will continue to compound by offering steady top-line growth, resilient margins and high, unleveraged returns on operating capital at reasonable valuations. These virtues are well in evidence for our high quality consumer staples holdings, and indeed throughout the broader Portfolio.1 In the short term, returns can be driven by rising P/E multiples, as was certainly the case in 2012 and 2013, but in the long term, we believe that the ability to steadily compound matters most.
