The Investec Global Franchise Fund seeks to provide some certainty in uncertain and volatile times by investing in quality companies. The Fund has an established track record of providing meaningful participation in up markets, smaller draw-downs in down markets and lower than average volatility. However, the Fund has underperformed over the last six months, delivering negative returns against a rising market. So, what has happened? Globally, the year 2016 was a tale of two halves. Opec’s agreement to cut output for the first time since 2008, and Donald Trump’s election victory with anticipation of fiscal stimulus, triggered expectations of stronger growth and reflation, with forecasts for rising rates and steepening yield curves in the US. The second half of the year saw a significant rotation in equity markets away from defensive yielding sectors (utilities, telecoms, health care, consumer staples) in favour of lower-quality, ‘cheap’, leveraged, capital-intensive and more cyclical sectors (notably financials, materials and consumer discretionary). This has affected our Fund’s performance, given our bias for more defensive quality positioning. We don’t hold the more capital-intensive, defensive yielding sectors (principally utilities and telecoms) in the Fund, which has helped performance at the margin.
The Fund’s six month performance profile is to be expected in a ‘risk-on’ environment with a short-term rotation away from quality. The performance of the Investec Global Franchise Fund still remains strong over the medium to long term. Historically, it’s been a good time to allocate into our Quality strategies after a period of weak performance. Over time, the Fund has delivered a more consistent return profile than the market in absolute terms, as shown by the rolling three-year returns in Figure 1 for the Investec Global Franchise Fund versus the MSCI All Country World Index (ACWI).
Figure 1: Rolling three-year returns – since inception*
*Launch simulation date: 10.04.07. Past performance should not be taken as a guide to the future, losses may be made. Data is not audited. Source: Morningstar as at 31.12.16. Returns are calculated on a lump sum, NAV to NAV basis, net of fees, with gross income reinvested, in USD. Market indices are gross of fees. Highest and lowest returns achieved during 12-month rolling periods since inception: 28.02.10: 54.4% and 28.02.09: -38.7%.
Although we are not macro forecasters, we believe that the market has got ahead of itself, and we are experiencing a modest cyclical rebound within a secular world of sluggish growth. We question whether the market is not significantly overestimating what Donald Trump can achieve. Is it only a matter of time before many of Trump’s populist pledges are exposed?
Fiscal stimulus is first on the agenda for Trump, to resuscitate growth and create inflation. Tax cuts and increased infrastructure spending may provide a short-term boost to economic growth. However, this will likely be followed by uncertainty in the face of anti-globalisation and anti-free-trade sentiment, which could have an impact on consumer spending and business investment. Furthermore, the US debt to GDP ratio is over 100% and the budget deficit is around US$600 billion. Is it rational to therefore believe that fiscal stimulus, presumably financed by deficits, will soon reverse years of stagnation?
The outlook for monetary policy is equally uncertain, with potential changes to both personnel and policy at the Federal Reserve (the Fed). In December, the Fed raised the federal funds rate target range by 25bps and anticipates three rate hikes in 2017. It is worth contemplating whether the rise in borrowing costs will blow gaskets across the world before fiscal stimulus arrives, if it in fact arrives.
And what about the reflation argument? In the US, the only real growth has come from consumption fuelled by a strong job market. In China, growth appears to have been boosted by a significant increase in debt. Higher interest rates do not support either driver. Other macro issues which may weigh on markets over the course of 2017 include political uncertainty in Europe, European bank stability, and commodity price volatility. Against this macro backdrop, we believe the global economic recovery remains uncertain.
We don’t believe the current market environment has significantly changed the fundamentals of the stocks in our Fund. However, the market rotation has resulted in quality stocks derating. Not only are our stocks cheaper than six months ago, they are of a higher quality (return on invested capital), in both absolute and relative terms. We have used the recent volatility to increase our exposure to stocks in which we have high conviction and where short-term weakness has provided a good buying opportunity (e.g. Reckitt Benckiser and Imperial Brands).
In our view, long-term structural growth is more important than macro-driven short-term cyclical growth. We will continue to focus on the individual companies that are still able to generate cash and reinvest that cash for growth at high returns. We argue therefore that, on a relative basis, the biggest risk for the portfolio is a sustained cyclical market rally, as this should benefit equities in general, but cheaper, more cyclical and economically sensitive lower-quality stocks would likely benefit more. We believe, however, that the Fund is not one-dimensional, and recent portfolio changes should reduce the reliance to any one market trend or sector.
We continue to find attractive opportunities in the consumer staples sector, in spite of perceived valuation concerns and lower exposure to any short-term cyclical recovery. However, over the last few years we have made significant changes to the Fund’s portfolio positioning, as illustrated in Figure 2.
The evolution in the Investec Global Franchise ‘core’ has reduced the consumer staples exposure to less than 40%, and increased the financials to approximately 10% and technology to more than 25%. We believe these enhanced diversification benefits should continue to contribute to a consistent return profile for the overall portfolio, regardless of the market environment.
Figure 2: Sector allocation since inception
Source: Investec Asset Management as at 31.12.16.
We have found some very interesting stock ideas in the technology and financials (excluding banks) areas of the market. For example, we recently purchased the likes of Automatic Data Processing, Visa, Priceline, Verisign and S&P Global.
Consumer staples are frequently referred to as bond proxies, and, in turn, the market often assumes that the sector is a proxy for quality. Increased expectations of interest rate rises in 2016 helped trigger consumer staples’ relative underperformance. However, we believe it is a flawed notion that consumer staples and hence quality, perform poorly in an environment of rising rates and steepening yield curves. The impact of rates on consumer staples varies greatly over time, and the correlation is usually at its highest when rates have bottomed. The much-anticipated inflection point in rates in 2016 meant that the market differentiated less between high- and low-quality consumer staple companies, slashing their multiples across the board. Not all consumer staples are high-quality compounders. Hence, we believe that going forward, variations in multiples across the sector will increase again and good stock picking will remain important.
While our Quality funds have defensive characteristics, we do not believe they should be considered bond proxies. There is little statistical relationship between our funds and long-dated bond securities or levels of the yield curve. In fact, it can even be argued that the correlation of the portfolio is positively skewed to higher bond yields, challenging the notion that the Fund will underperform the market in a rising rate environment, for the following reasons:
But one should be careful painting a sector-level brush across Quality strategies and deriving conclusions. We are fundamental, bottom-up quality stock pickers. We believe understanding the sensitivity of our individual companies to changes in yields is a more important consideration. We therefore analysed the sensitivity of our funds, on a stock level, to changes in US 10-year Treasury yields. Our analysis revealed that the relative marginal contribution for the Investec Global Franchise Fund – the percentage of Global Franchise returns explained by the performance of 10-year US Treasuries – is only 6.4%. This means that 93.6% of Global Franchise returns are actually explained by other factors.
Finally, it is worth bearing in mind that the quality companies we seek to invest in have very little debt. Therefore, they shouldn’t struggle to refinance debt at the higher rates that bond markets are now pricing in. Banks/financials may benefit in the short term from higher rates, but we question how much expectations here are now priced in or even excessive. In the absence of growth, will rising rates lead to loan defaults (both consumer and corporate) longer term?
Our portfolio is built from the bottom-up with a long-term focus, targeting cash-generative companies able to sustain high returns on invested capital. The companies typically have low sensitivity to the economic and market cycle. While macro and thematic opportunities and threats are carefully considered, these factors are assessed at a stock level. The long-term strength of a company’s business model and the sustainability of its competitive advantage form an integral part of our bottom-up analysis.
We have experienced a modest cyclical rebound within a secular world of sluggish growth. The Investec Global Franchise Fund has performed as expected in this ‘risk-on’ environment. Fundamentally, we believe nothing has changed in terms of how quality companies can provide long-term outperformance, and we have used the recent volatility to increase stocks where we have high conviction. Most importantly, performance of the Fund remains strong over the long term.
Figure 1: Old Economy = Following subsectors: Old Consumer Discretionary (Auto, Household Durables, Specialty Retail, Textiles, Apparel & Luxury Goods), Old Consumer Staples (Beverages, Food & Staples Retailing, Food Products), Energy, Old Industrials (Capital Goods, Transportation), Materials, Real Estate, Telecommunication Services, Old Utilities (IPPs); New Economy = Following subsectors: New Consumer Discretionary (Diversified Consumer Services, Internet and Catalogue Retail, Media), New Consumer Staples (Personal and Household Products), Healthcare, New Industrials (Aerospace & Defence, Commercial & Professional Services), Information Technology (Software & Internet, Semiconductors, Technology Hardware), New Utilities (Gas Utilities, Renewable Electricity, Water Utilities) Time period shown covers the period for which we have reliable data. For further information on investment process, please see the Important Information section.
Collective investment schemes (CIS) are traded at ruling prices and can engage in borrowing, up to 10% of portfolio net asset value to bridge insufficient liquidity, and scrip lending. A schedule of charges, fees and advisor fees is available on request from the Manager, Investec Fund Managers SA (RF) (Pty) Ltd (IFMSA) which is registered under the CIS Control Act. Additional advisor fees may be paid and if so, are subject to the relevant FAIS disclosure requirements. CISs are generally medium to long term investments and the manager gives no guarantee with respect to the capital or the return of the Fund. The value of participatory interests (units) may go down as well as up. Individual investor performance may differ as a result of initial fees, actual investment date, date of any subsequent reinvestment and any dividend withholding tax. Different classes of units apply to the fund and the information presented is for the most expensive class. Fund valuations and transaction cut-off time are 16h00 SA time each business day. These portfolios may be closed in order to be managed in accordance with the mandate. Fluctuations or movements in exchange rates may cause the value of underlying international investments to go up or down. Where portfolios invest in the participatory interests of foreign collective investment schemes, these may levy additional charges which are included in the relevant TER. A feeder fund is a portfolio that, apart from assets in liquid form, consists solely of participatory interests in a single portfolio of a CIS which levies its own charges which could then result in a higher fee structure for the feeder fund. Fund prices are published each business day in selected media. 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. Investec Asset Management (Pty) Ltd (“Investec”) is a member of the Association for Savings and Investment SA (ASISA). The scheme trustee is FirstRand Bank Limited, PO Box 7713, Johannesburg, 2000, Tel: (011) 282 1808. The dollar-denominated funds are sub-funds in the Investec Global Strategy Fund, 49 Avenue J.F. Kennedy, L-1855 Luxembourg, Grand Duchy of Luxembourg, and are approved under the CIS Control Act. IFMSA products are subject to the terms contained in the IFMSA Terms Document, as well as the Minimum Disclosure Document, which is available from our website www.investecassetmanagement.com.
All information and opinions provided are of a general nature and are 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 or opinion without appropriate professional advice after a thorough examination of a particular situation. Past performance of investments is not necessarily a guide to future performance. This is not a recommendation to buy, sell or hold securities. This is the copyright of Investec and its contents may not be re-used without Investec’s prior permission. Investec Asset Management is an authorised Financial Services Provider. Issued by Investec Asset Management, February 2017.