Global Franchise Outlook

In spite of perceived valuation concerns and lower exposure to any short-term cyclical recovery, Clyde Rossouw, Co-Head of Quality bei Investec Asset Management, continues to find attractive opportunities in the consumer staples sector.

Last year we predicted that near-term interest rate normalisation in the US was unlikely, given continued challenging economic conditions and a strong US dollar. We also predicted that, in spite of weak corporate earnings, investors may nonetheless remain greedy in the face of steeper valuations, as long as accommodative central bank policy and the provision of cheap money continued. Ultimately, we did not believe this situation was sustainable and predicted a market correction at some point, but this has yet to materialise. Instead, risk appetite has strengthened.

The question for investors as we move into 2017 is: ‘How sustainable is this risk-on trade and the value rally that we have witnessed in 2016?’ Will monetary and fiscal policy provide effective stimulus for economic growth? Or will growth falter under the weight of ever-higher public and private debt, increasingly protectionist US government policy, and more hawkish US Federal Reserve policy in the face of rising inflationary pressures?

Global economic recovery
We believe the global economic recovery remains uncertain. There will be political uncertainty as Brexit negotiations unfold, key national elections take place in France and Germany, and Trump takes over the US presidency. The outlook for monetary policy is equally uncertain, with potential changes to both personnel and policy at the Federal Reserve. Fiscal stimulus through tax cuts and increased infrastructure spending may provide a short-term boost to economic growth. However, there will likely be uncertainty in the face of anti-globalisation and anti-free-trade sentiment, which will be expected to have an impact on consumer spending and business investment.

Over the last year, we have seen huge dispersions in the performance of stocks within sectors, as well as between sectors. Against a backdrop of market volatility and heightened valuations, we believe the biggest ‘theme’ for 2017 will be stock selection. It will be those individual companies that can grow in uncertain times that will be most likely to prevail.

Where are the investment opportunities?
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, with typically low sensitivity to the economic and market cycle. While macro and thematic opportunities and threats are carefully considered, this is done at the individual company level in our assessment of the long-term strength of a company’s business model and the sustainability of its competitive advantage. 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.

For example, after an extensive review, we recently added to our long-held position in Reckitt Benckiser on short-term weakness. This company has a proven track record of consistent organic revenue growth, even during the global financial crisis. Margin expansion has been achieved through cost efficiencies and a focus on the company’s higher-margin divisions such as consumer health, leading to even better earnings growth which has converted fully into cash. The strength and the reliability of this cash generation has enabled Reckitt Benckiser to invest in innovation and advertising and promotion, supporting its brands, improving its market share and providing a significant runway for growth at high returns on capital. This virtuous cycle is reflected in the performance it has delivered for shareholders. As shown in Figure 1, this performance has been driven almost entirely by the compounding of cashflows, with very little coming from a re-rating of the shares. We believe these drivers remain firmly in place and the company is well positioned to continue to deliver strong performance from here.

Not all consumer staples are high-quality compounders, however, and not all high quality compounders are consumer staples. Over the last few years we have also found some very interesting stock ideas in other areas of the market, in particular the technology and financials (excluding banks) sectors. So much so that our consumer staples exposure has nearly halved over the last five years to less than 40% at the time of writing, with technology companies now representing over 25% of the portfolio and financials around 10%.Growth in the internet and disruptive technological change has given rise to some fast growing, capital light, cash generative, high-margin and high-return businesses. Examples range from digital payment platforms and payment networks to internet domain name registries and online travel agents. While they do not necessarily have the same trading histories as many of the consumer staples and pharmaceutical companies we hold, they nonetheless share similar attributes. They have strong and durable competitive advantages, protected by significant barriers to entry. By including these stocks in the portfolio we have sought to enhance the strategy’s growth and return characteristics without compromising materially on valuation.

Major risks for 2017
The performance signature of the strategy has historically been one of seeking to participate meaningfully in ‘up’ markets, with smaller drawdowns in ‘down’ markets, and lower-than-average volatility. Therefore, on a relative basis, we believe the biggest risk for the portfolio is a sustained market rally driven by polices aimed at stimulating economic growth. This should benefit equities in general, but cheaper, more cyclical and economically sensitive lower-quality stocks would likely benefit more.

In this scenario we may be on the wrong side of the mean reversion trade that has been so conspicuously absent in recent years. However, recent portfolio changes as outlined above have reduced the portfolio’s sensitivity and reliance to any one market trend or sector. Enhanced diversification benefits should continue to contribute to a consistent return profile for the overall portfolio, regardless of market environment. We would still expect positive absolute returns in this case.

Another risk is the outlook for interest rates. Perceived wisdom is that quality performs poorly in an environment of rising rates and steepening yield curves. The theory goes that stable future bond-like cashflows are discounted at higher rates, reducing their present value. There are a number of reasons, however, why we think this risk is mitigated within our strategy. While it has defensive qualities, it is in no way a bond-proxy strategy. Free cashflow has been growing at high single digit annual rates, and we seek to avoid some of the most rate-sensitive bond-like parts of the market such as utilities, telecoms and property. In aggregate, the companies we hold are typically not reliant on leverage to fuel growth and have very little debt, meaning they do not face the risk of having to refinance at higher rates. Overall, our consumer staples positioning has reduced over the last few years, as highlighted above, in favour of interesting defensive growth opportunities primarily in technology and financials. As a result, the correlation of the portfolio is actually positively skewed to higher bond yields.

Finally, one of the most common questions we are asked is about the valuation of quality stocks – are they expensive? It is important to remember here that any valuation of quality stocks needs to be made in the right context. Quality businesses are more expensive than they have been in the recent past, but ironically far more valuable in today’s low-return world. In the context of longer-term history, valuations of the wider equity market, bond yields, and quality attributes, we do not believe current valuations are stretched. Quality stocks have proven their ability to compound shareholder wealth over the long term at higher rates of return and with lower volatility than the wider market. We believe high barriers to entry, pricing power, high-quality profits, low financial leverage, low capital intensity, and consistently strong free cashflow generation, together mean that quality stocks are just as relevant now as they have proven to be over the long term.