Saxo Morningstar Moat portfolio – Q1 2019 commentary
|Asset classes||Global equities (excluding emerging markets)|
|Investment style||Fundamental analysis focused on quality and value|
|Quarterly return||+11.5% (net of fees)|
|Annualised volatility (since inception)||15%|
Once again, we find ourselves in a positive setting. Both equities and bonds rallied quite substantially in the first quarter of 2019, posting returns that many would be happy with over a year let alone three months. This denoted a backflip from late 2018, nullifying the meaningful drawdown incurred during Q4 2018 and taking some markets back towards all-time highs. Longer-term returns have also reverted to the higher side of normality, with the 2008 crisis seemingly a distant memory.
For the quarter, a few dominant forces drove market outcomes. Perhaps the most prominent driver was a change in direction from the Federal Reserve, moving from an assertive hiking path into a ‘wait and see’ approach. This led to the market swiftly repricing its expectations from rate rises to cuts, and equity and bond markets jumped, leaving both assets at worse valuations than they started the year. Notably, the dramatic decline in bond yields were key in driving strong returns for yield-sensitive asset classes (including global listed property), leading to further stretched valuations in this space.
Underlying this was some dispersion, offering the opportunity to think and act selectively. Emerging markets have been a mixed bag, with mainland China spiking in the quarter (well over 20% in local currency terms), yet the broad emerging basket modestly underperformed developed markets. Japan and Germany are also interesting, where 10-year government bond yields have fallen back below zero while stocks look relatively attractive. The US sits at the other end of the spectrum, despite stocks and bonds having a good quarter, where we have fancied the defensive characteristics of US bonds.
Best performing positions
- Stericycle Stericycle is the largest US-regulated medical waste management service to large quantity generators (such as hospitals). A good earnings announcement helped create positive sentiment for the stock, allowing it to rally substantially in the quarter. We have trimmed exposure in the portfolio given the rally, but otherwise maintained into Q2 2019 on the basis it is still undervalued in the market.
- Hanesbrands is a US-based, market-leading manufacturer of basic and athletic apparel under brands including Hanes, Champion, Playtex, Bali and Bonds. The company sells wholesale to discount, mid-market and department store retailers, as well as direct to consumers. The stock price rallied above the general market in Q1 on the back of strong earnings results for the fourth quarter of 2018. Given its rally, the stock price’s discount to fair value has reduced (less attractive) and as such the position is now sold for other opportunities.
- Alexion Pharmaceuticals specialises in developing and marketing drugs for rare, life-threatening medical conditions. Its blockbuster product, Soliris, is approved for paroxysmal nocturnal hemoglobinuria, atypical hemolytic uremic syndrome and generalised myasthenia gravis. Some poor management decisions in the past had left the company facing some turbulent years. Now at the other side of this, Alexion’s launch and approval of another drug, Ultomiris, offers promise and indicates the stock price remains undervalued. This position is held into Q2 2019.
Worst performing positions
- Bayer is a German healthcare and agriculture conglomerate. Healthcare provides over half of the company's sales and includes pharmaceutical drugs as well as vitamins and animal health products. It took a tumble in Q1 2019 as a San Francisco jury found its glyphosate product caused a case of cancer. Yet scientific studies remain supportive for the drug and the position is held into Q2 on the basis it has strong advantages above its competition.
- Adient is the leading seating supplier to the industry with nearly 40% share in both North America and Europe, as well as a dominant Chinese share of about 45%. Its stock price fell over the quarter as expectations for the automotive industry declined and some research houses, including credit rating agency Moody’s, cut their expectations for Adients’ growth. While Morningstar is also aware of industry conditions, it feels the company is in a strong position versus its peers and the stock price remains discounted versus its fair value. The position is kept into Q2.
- Tenneco produces emissions control products to meet strict air quality legislation, as well as ride control and performance products for vehicles. Its stock price has struggled with the acquisition of Federal-Mogul from Icahn Enterprise for an enterprise value of USD 5.4 billion, and further knocked in March by underwhelming Q4 2018 earnings results. Tenneco expects the acquisition to create a powertrain auto-parts supplier with more than USD 10 billion in annual revenue. The position is held into 2019 with its valuation heavily discounted versus the estimated fair price.
Into the next quarter, we must not forget the US Fed is changing course in response to a souring economy — with bond markets purportedly pricing in a recession — plus additional signs that growth is slowing elsewhere. Fundamentally, corporate profit warnings are also becoming more common, which seems to contradict the compression in corporate bond yields. This is especially prevalent among riskier bonds (sub-investment grade), where yields are back to historically low levels.
Of course, there are other factors playing into proceedings. Brexit is a threatening outlier, but didn’t really impact asset prices outside the daily vicissitudes of UK assets. The price of sterling remains sensitive to change — as the place investors tend to express their views first — but bucked the Brexit negativity and rose somewhat in the quarter (slightly reducing returns for unhedged international holdings). The trade war negotiations also linger on but didn’t dent the recovery in emerging markets or US assets.
As such, we face an interesting period that requires careful longer-term positioning. The positive returns are a welcome change from the late-2018 challenges, although the undercurrent remains susceptible to stretched valuations and a maturing market cycle.