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Investment views

Seeking greater certainty in uncertain times

11 February 2019
Author: Clyde RossouwPortfolio Manager

As volatility and uncertainty continue into 2019, we believe stock selection will be key for equity investing. Applying an active bottom-up quality approach can help navigate current market turbulence with greater certainty than passively submitting to market movements. We also look to the resilience of quality companies not just for the present, but for the future. We believe structural growth will underpin the sustainability of these businesses for the long term.

Uncertainty in the market continues into 2019

The investment environment remains challenging and uncertain as we enter the new year. Global growth appears to be weakening; trade tensions continue between the US and China; political risk is increasing in both developed and emerging markets; debt levels remain elevated across government, corporate and household sectors; and monetary conditions are tightening in the short term as central banks shift to more hawkish policies.

These challenges have manifested themselves in increased volatility in equity, commodity and currency markets, falling US Treasury yields and widening credit spreads. At the company level, as seen in particular by Apple’s recent revenue warning, forecasts in many cases are being revised downwards.

The prospects for 2019, therefore, remain uncertain for equity market investors. However, we believe that by following an active quality approach it is possible to provide better downside protection than the market, while still delivering strong through-cycle performance, in both absolute and relative terms.

A fund seeking to reduce uncertainty

As shown below, the Investec Global Franchise Fund (‘the Fund’) has outperformed its performance comparison index since inception in 2007, through the volatility of 2018, and most recently through the market turbulence experienced in Q4 2018.

Figure 1: Annualised performance

Figure 1: Annualised performance

Past performance is not a reliable indicator of future results, losses may be made.

Source: Investec Asset Management, as at 31.12.18. Performance is net of fees (NAV based, including ongoing charges, excluding initial charges), gross income reinvested, in USD. If the share class currency differs from the investor’s home currency, returns may increase or decrease as a result of currency fluctuations. Highest and lowest 12-month rolling performance since inception* is 54.4% (28.02.10) and -38.7% (28.02.09) respectively.* Inception date 10 April 2007. The performance is based on the OEIC Investec Global Select Equity Fund from 10 April 2007 which then merged into the Luxembourg-domiciled Investec GSF Global Franchise Fund on 04 July 2009. ** Comparison index: At Inception = MSCI World NR; Current since 1 October 2011 = MSCI AC World NR.

Our search for Quality

Our active quality-focused investment approach has remained consistent since inception of the the Fund in 2007, and has delivered strong performance through different market environments. In times of uncertainty, the quality attributes we seek do not change. Rather, they provide the necessary ingredients for our companies to continue to compound shareholder wealth.

We outline these key attributes below, and explain why they are particularly suitable for current uncertain market conditions.

1. Hard-to-replicate, enduring competitive advantages

High quality companies have enduring competitive advantages, typically in the form of intangible assets such as brands, patents, licenses and networks, that create barriers to entry that protect them from competitive threats. As a result, these companies have been able to establish dominant positions in their industries and deliver persistent growth in intrinsic value, even through periods of economic and market weakness.

One such example is Visa, the global payments technology company. Visa and Mastercard (its closest competitor) have dominated payment processing for decades. Last year alone, Visa’s vast network processed 124 billion transactions globally, enabling the company to grow its net operating revenues by 12%, generate $12bn of free cash flow, and return over $9bn back to investors through share buybacks and dividends. As a result, Visa delivered total returns to shareholders of 16.5% in 2018, outperforming the MSCI ACWI by more than 25%.

2. Low sensitivity to the economic and market cycle

Another key attribute of quality companies is resilience in times of economic and market stress. Defensive characteristics, resilient cash flow generation and low cyclicality have enabled quality companies to survive multiple economic cycles with their market position and competitive economics intact. This has enabled them to deliver returns to shareholders that have been not only stronger than the market, but also relatively defensive and uncorrelated.

Nestle and Unilever are examples of high quality defensive companies. Both have large portfolios of dominant brands, generate recurring revenues from repeat purchases of everyday low-ticket items, are globally diversified, and are well positioned in attractive categories, markets and channels. As well as compounding shareholder wealth over the long term, both stocks also demonstrated their defensive qualities in the short term, significantly outperforming the market through Q4 2018 when the MSCI ACWI fell by 13%.

3. Healthy balance sheets and low capital intensity

A strong financial model is critical to successfully navigate more challenging economic and market conditions. Low financial leverage and low capital expenditure requirements provide valuable operational flexibility for high quality companies in times of market weakness. In contrast, highly leveraged low quality companies could see further stress put on their balance sheets should rates continue to rise and cash flows weaken.

Since inception, the portfolio constituents in the Fund have demonstrated consistently lower debt levels than the wider market. As at 31 December 2018, net debt/EBITDA for the Global Franchise portfolio was 0.27x, more than six times lower than the corresponding figure for the MSCI ACWI of 1.71x.

Figure 2: Low leverage (Net Debt to EBITDA)

Figure 2: Low leverage (Net Debt to EBITDA)

Sources: Investec Asset Management and FactSet, 31.12.18. Past performance should not be taken as a guide to the future, losses may be made. Investec Global Franchise Fund reweighted excluding cash and equivalents, since inception.

4. Strong cashflow generation and disciplined capital allocation

The generation and strategic allocation of cash is a vital determinant of the sustainability of a company’s long-term growth. Top line revenue growth is not enough if this does not feed through to cashflow, which in turn needs to be allocated responsibly and efficiently and in alignment with the interests of shareholders and other key stakeholders. We are therefore wary of companies where future cashflows are uncertain yet high multiples are pricing in significant long-term growth. Shares in such companies can be very volatile, particularly at times of investor nervousness, as we saw with certain technology stocks in the second half of 2018.

An example of the type of technology stock we do own is Microsoft. Its transformation has been primarily organic through highly effective capital allocation. It has now become a dominant player in cloud computing with significant long-term structural growth prospects and generates free cashflow in excess of $30bn annually, and has net cash on the balance sheet of around $50bn. Effective capital allocation and a highly cash generative business and financial model have enabled Microsoft not only to deliver very strong performance over time, but also to demonstrate greater resilience than the wider market and technology sector through last year’s volatility.

In search of future resilience and structural growth

As well as providing resilience in current volatile markets, quality companies are also ‘future-proofing’ their businesses by continually investing in Research & Development (R&D). This investment helps drive product innovation and improves brand awareness and loyalty. In so doing, it not only contributes to self-funded future growth, but also strengthens barriers to entry and protects companies from disruption and competitive threats. In aggregate, companies in the Global Franchise portfolio spend roughly 3.5 times more on R&D as a percentage of sales than the wider market, and still generate far higher levels of profitability.

Figure 3: Strong investment in R&D

Figure 3: Strong investment in R&D

Source: FactSet, based on constituents of MSCI ACWI, as at 31.12.18.
Past performance should not be taken as a guide to the future, losses may be made. Investec Global Franchise Fund re-weighted excluding cash and equivalents, since inception.

As companies evolve to deal with disruptive technological forces and structural changes to the industries in which they operate, we have also evolved the Global Franchise portfolio while staying true to our quality approach. The charts below show how we have maintained our quality premium to the market since inception, as measured by Return on Invested Capital (ROIC), but have significantly changed our sector allocation over time as the quality opportunity set has evolved.

Figure 4: Effective capital allocation (ROIC)

Figure 4: Effective capital allocation (ROIC)

Sources: Investec Asset Management and FactSet, 31.12.18.
Past performance should not be taken as a guide to the future, losses may be made. Investec Global Franchise Fund re-weighted excluding cash and equivalents, since inception. The ROIC is different from the actual fund performance and past performance is not a guide to the future.

Figure 5: Sector breakdown since inception

Figure 5: Sector breakdown since inception

Source: Investec Asset Management, FactSet, 31.12.18. Data is run monthly based on Investec Global Franchise Fund.

We have reduced our exposure to consumer staples companies most impacted by disruptive threats such as private label penetration, brand proliferation, ecommerce and digital advertising, which are most acute in the US and in categories such as food and certain household products. Attractive opportunities still do exist in consumer staples, particularly given global trends in health and wellness, personal care and a continuing long-term shift to more consumer-based economies in emerging markets, but stock selection remains key.

We have increased our exposure primarily to select, high quality, attractively valued and cash generative technology stocks. In addition to Microsoft and Visa, these include companies such as Verisign, the registry behind .com and .net domain names, Intuit, the accountancy software business, and ASML, the near monopoly manufacturer of lithography equipment used in computer chip design. These companies are at the forefront of technological change, benefiting from growth in internet usage and cloud computing, as well as new technologies such as robotics, Artificial Intelligence, augmented reality and the Internet of Things.

Overall, while the Fund’s attractive quality characteristics have not changed materially over time, we believe the portfolio has evolved with the changing investment landscape and is well positioned to take full advantage of global themes, future trends and structural growth opportunities in high quality stocks.

Valuation discipline is essential

Finally, it is important to maintain valuation discipline by investing in quality companies at reasonable prices, not quality at any price, particularly in volatile and uncertain markets such as these. Valuations must be properly assessed in context, whether that context be the quality one is paying for, longer term history, the wider market or other asset classes. In our view, this helps protect the portfolio on the downside. As the chart overleaf shows, the valuation of Global Franchise is in line with the wider index as measured by free cash flow (FCF) yield, and by EV/ EBIT (which, unlike the P/E ratio, accounts for debt as well as equity on the balance sheet), yet offers a significant premium in terms of quality, as measured by ROIC to indicate profitability and Net Debt/EBITDA to indicate balance sheet strength. This provides us with further conviction in the long-term return potential for quality stocks.

Figure 6: Growth at a reasonable price, not at any price

Figure 6: Growth at a reasonable price, not at any price

The portfolio may change significantly over a short period of time. Source: FactSet, Investec Asset Management, 31.12.18. Past performance should not be taken as a guide to the future, losses may be made. Investec Global Franchise Fund re-weighted excluding cash and equivalents, since inception. The ROIC is different from the actual fund performance and past performance is not a guide to the future. Financial metrics are based on blended forward and trailing financial data according to individual constituent company fiscal year ends. FCF Yield calculation excludes companies classified in the Banks Industry Group according to GICS.

Conclusion

The Investec Global Franchise Fund has exhibited good defensive characteristics in down markets where it has typically experienced smaller drawdowns. Given the Fund’s Quality bias and relatively low beta of less than 0.8, we would expect moderate and falling markets to provide the main source of outperformance, in return for giving up some returns in more bullish markets. As the chart below shows, since inception, we have generally kept pace with strong markets, and significantly outperformed in more moderate and falling markets.

Figure 7: Growth and resilience through uncertain markets

Figure 7: Growth and resilience through uncertain markets

Past performance is not a reliable indicator of future results, losses may be made.

Source: Investec Asset Management, 31.12.18. Performance is net of fees (NAV based, including ongoing charges, excluding management fees and initial charges. Management fees are agreed and invoiced outside of the share class, performance would have been lower had these fees been included.), gross income reinvested, in USD. If the share class currency differs from the investor’s home currency, returns may increase or decrease as a result of currency fluctuations. Highest and lowest 12-month rolling performance since inception is 54.4% (28.02.10) and -38.7% (28.02.09) respectively. For further information on indices, please see the Important Information section.

As the outlook ahead remains uncertain with the potential for more market volatility, we maintain conviction in our investment approach. We continue to position our portfolio for resilience and structural growth by focusing on attractively valued quality companies (as evidenced by our top 10 holdings below) with relatively low sensitivity to the economic and market cycle. We believe that the active, discretionary approach we take to investing in the evolving universe of Quality stocks will serve our clients well.

Figure 8: Top 10 by portfolio weight

NAME WEIGHT
Visa 8.0%
Microsoft 6.6%
Verisign 5.5%
21st Century Fox 5.1%
Booking 5.1%
NAME WEIGHT
Johnson & Johnson 4.8%
Moody's 4.6%
Nestlé 4.4%
Roche Holding 4.1%
Beiersdorf 3.8%
Total 51.9%

This is not a buy, sell or hold recommendation for any particular security. The portfolio may change significantly over a short period of time. Source: FactSet, 31.12.18.

 


Important information

All information provided is product related, and is not intended to address the circumstances of any particular individual or entity. We are not acting and do not purport to act in any way as an advisor or in a fiduciary capacity. No one should act upon such information without appropriate professional advice after a thorough examination of a particular situation. This is not a recommendation to buy, sell or hold any particular security. Collective investment scheme funds are generally medium to long term investments and the manager, Investec Fund Managers SA (RF) (Pty) Ltd, gives no guarantee with respect to the capital or the return of the fund. Past performance is not necessarily a guide to future performance. The value of participatory interests (units) may go down as well as up. Funds are traded at ruling prices and can engage in borrowing and scrip lending. The fund may borrow up to 10% of its market value to bridge insufficient liquidity. A schedule of charges, fees and advisor fees is available on request from the manager which is registered under the Collective Investment Schemes Control Act. Additional advisor fees may be paid and if so, are subject to the relevant FAIS disclosure requirements. Performance shown is that of the fund and individual investor performance may differ as a result of initial fees, actual investment date, date of any subsequent reinvestment and any dividend withholding tax. There are different fee classes of units on the fund and the information presented is for the most expensive class. Fluctuations or movements in exchange rates may cause the value of underlying international investments to go up or down. Where the fund invests in the units of foreign collective investment schemes, these may levy additional charges which are included in the relevant Total Expense Ratio (TER). A higher TER does not necessarily imply a poor return, nor does a low TER imply a good return. The ratio does not include transaction costs. The current TER cannot be regarded as an indication of the future TERs. Additional information on the funds may be obtained, free of charge, at www.investecassetmanagement.com. The Manager, PO Box 1655, Cape Town, 8000, Tel: 0860 500 100. The scheme trustee is FirstRand Bank Limited, PO Box 7713, Johannesburg, 2000, Tel: (011) 282 1808. Investec Asset Management (Pty) Ltd (“Investec”) is an authorised financial services provider and a member of the Association for Savings and Investment SA (ASISA). A feeder fund is a fund that, apart from assets in liquid form, consists solely of units in a single fund of a collective investment scheme which levies its own charges which could then result in a higher fee structure for the feeder fund. The fund is a sub-fund in the Investec Global Strategy Fund, 49 Avenue J.F. Kennedy, L-1855 Luxembourg, Grand Duchy of Luxembourg, and is approved under the Collective Investment Schemes Control Act.
This document is the copyright of Investec and its contents may not be re-used without Investec’s prior permission. Issued by Investec Asset Management.

Clyde Rossouw
Clyde Rossouw Portfolio Manager

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