Virtus Global Opportunities Fund
3Q 2016 COMMENTARY
MARKET — Over the third quarter, equity investors saw generally low volatility and positive markets globally. Global markets were supported by solid economic performance in the U.S. and the outlook for higher interest rates. Elsewhere, returns were driven by the U.K. equity market’s bounce back from the Brexit sell-off, continued loose monetary policy in developed markets, and performance of key emerging markets, such as China, India, Korea, and Taiwan.
PERFORMANCE — While the Fund’s performance was positive and style-consistent for a quality growth-focused strategy, it underperformed the strong performance from the MSCI All Country World Index in the quarter. Weak performance in the consumer staples sector weighed on the overall return. In many sectors, P/E ratios are towards the high end of their historic ranges. There is a risk that valuations could pull back when interest rates rise. We are cognizant of this environment and evaluate the P/E ratio of each holding relative to its own history. Over the course of this year, we trimmed back some positions that had reached our price targets. Our sector weightings haven’t changed significantly from the previous quarter. One notable change is that we further added to our U.S. and Chinese e-commerce exposure. Our Chinese exposure does not reflect a top-down view on China, rather a deepening of our conviction of the long-term growth potential of some leading Chinese e-commerce companies.
OUTLOOK — We caution investors that, given our consistent focus on investing in high quality growth companies, our relative performance could suffer from continued flows into cyclical areas or a further appreciation in oil or commodity prices. Through our in-depth, fundamental research, we continue to find new opportunities.
Global markets were driven by a rapid recovery from the Brexit sell-off, continued loose monetary policy in developed markets, and performance of key emerging markets, such as China, India, Korea, and Taiwan. Sentiment of exhaustion of expansionary monetary policies impacted interest rate-sensitive sectors, spurring a rotation into financial stocks (banks and insurers) and out of consumer staples, telecommunications services, and utilities.
Optimism about U.S. economic improvement helped fuel markets during the quarter. Employment in the U.S. has strengthened, although jobs gains in August were not as strong as gains during the preceding months. We believe consumption remains the engine behind the U.S. recovery, and consumer confidence has risen to levels last seen before the financial crisis.
In July, a robust June jobs report topped consensus expectations and better sentiment surrounded the second quarter earnings season. As markets had expected, the U.S. Federal Reserve refrained from raising rates during its July meeting, while leaving the door open for an increase before year-end. In August, Fed Chair Janet Yellen stated that the case for a rate hike strengthened in recent months, raising market expectations that tightening would occur before year-end. In September, volatility, which had been low during much of July and August, ratcheted higher when Federal Reserve members gave conflicting statements about a September rate hike. The Federal Open Market Committee opted not to tighten at its September meeting. Ms. Yellen acknowledged that progress has been made towards the Fed’s goal of full employment. A November or December rate increase remains possible. However, the Fed anticipates fewer increases and more gradual tightening than it did previously.
Over the quarter, the Bank of Japan (BOJ) announced the decision to implement yield curve controls, intending to maintain 10-year Japanese government bond yields at zero percent. Many analysts had expected the central bank to take short rates deeper into negative territory. Some believe the new policy is a stealth tightening.
In Europe, the recovery continues, with the jobs market appearing to have stabilized. Unemployment was 8.6% in July, down from 9.4% in July 2015 (Source: Eurostat, based on EU28). Structural reforms continue to support private sector activity, and significantly reduced labor costs have improved the competitiveness of some companies and the external position of some countries. Economic and business sentiment improved during September, following three months of negative or flat sentiment. Valuations across Europe remained attractive although Europe’s banking challenges were spotlighted during the quarter. Sagging bank profitability owes much to the staid pace of economic growth, the flat yield curve, and ultra-low (sometimes negative) interest rates. All are rooted in the European Central Bank’s (ECB) efforts to boost inflation.
The U.K. economy was not significantly impacted following Brexit. Political clarity was improved when Theresa May was appointed prime minister, economic stimulus was applied when the Bank of England cut rates, and markets moved higher as the pound dropped about 13% against the U.S. dollar (Source: Bloomberg). In addition, the new chancellor indicated a different approach to fiscal policy is ahead. The Autumn Statement is expected to include stimulus measures, such as tax cuts and/or accelerated infrastructure spending.
After a disappointing 2015 (-14.9%, as measured by the MSCI Emerging Markets Index), emerging markets were top performers through the third quarter of 2016. Lower-than-expected interest rates in the U.S. continued to support demand for higher-yielding assets in the emerging world. Improved capital flows have helped some emerging market currencies recover lost ground relative to the U.S. dollar, reducing the cost of imported goods and supporting the domestic consumer. Stabilizing commodity markets also helped during the quarter.
Brazil has suffered debilitating internal political and economic crises that culminated in the impeachment of President Dilma Rousseff. On August 31 Michel Temer became Brazil’s new president. He hails from the opposition PMDB (Partido do Movimento Democrático Brasileiro, the Brazilian Democratic Movement Party) and is committed to implementing fiscal reforms, limiting the government’s ability to spend. Despite Brazil’s deep recession and economic contraction, it was one of the best performing emerging markets during the quarter, up 11.3% as measured by the MSCI Brazil Index.
India’s growth slowed year-over-year during the second quarter, but the country continues to expand its economy far faster than other nations. Inflation came in below expectations during the period, which opens the door to more stimulative central bank policy, and business confidence improved in September. Markets reacted positively to the Indian government’s passing of the Goods and Services Tax Bill (GST) which overhauls much of the current mix of central and state taxes. It is expected to reduce double taxation, bring parts of India’s large informal economy on the books, and lower the cost of doing business across state lines. The MSCI India ND Index returned 5.9% in U.S. dollars (USD) for the quarter.
China’s economic growth appears to have stabilized. Chinese e-commerce companies continue to deliver strong growth, taking market share away from traditional retailers and supported by the surging use of mobile. Over the quarter, Chinese authorities approved the Shenzhen-Hong Kong Connect. The new Connect will give Hong Kong investors greater access to technology companies, which comprise approximately 20% of the Shenzhen Exchange. The MSCI China ND Index returned 13.9% (USD) for the quarter.
While global markets increased over the quarter, risks persist. Political risks have created a new and significant overhang in Europe. The Brexit vote appears to have galvanized populist sentiment and anti-establishment, anti-immigration political groups. Banking issues have contributed to the vulnerability of Italy’s prime minister, Matteo Renzi, ahead of December’s constitutional referendum. And the failed coup in Turkey created an uncertain political and economic environment.
While the Fund’s performance was positive, it underperformed the MSCI All Country World Index in the quarter. Over the one-year period, the Fund performed in line with the Index. The Fund’s relative outperformance for the first half of 2016 was largely driven by our overweight to the consumer staples sector, which was bolstered by investor preference for higher-yielding, lower-volatility stocks, and where some investors have thought of consumer staples as bond proxies. But, in the third quarter, the trend reversed with cyclical areas outperforming as the market began to price in the potential for increased interest rates in the U.S.
Consumer Staples — Given the relative softness in the consumer staples sector over the quarter, our large exposure (31% of the portfolio) weighed on overall returns. Specifically, our tobacco holdings Reynolds American and Altria underperformed. Reynolds reported second quarter results that were lower than expected, on weaker industry volumes, and the company narrowed its guidance in a way which implied consensus was too high. But, on the positive side, Reynolds increased its dividend and announced a new buyback program, increasing its cash return to shareholders. Taking a step back and looking at the longer term fundamentals of the business, Reynolds American is a strong second in both cigarettes and smokeless tobacco in the U.S. During the quarter, Altria, the largest U.S. tobacco company, reported second quarter results that showed volumes in the U.S. are reverting to historical trends, which was partially offset by positive pricing and cost savings. Altria has leading positions in cigarettes, smokeless tobacco, and machine-made cigars. The company's long-term goal, which we believe is achievable, is to consistently grow earnings 7-9% and use the majority of its hefty free cash flow as dividends and the rest for share buybacks. The U.S. tobacco market is consolidated, the industry players largely raise prices together and the consumer accepts these increases. Although one of the world’s most mature markets, we are confident in its profit growth due to the strong pricing environment.
Health Care — Our holdings in health care also detracted from returns, specifically driven by Bristol Myers Squibb, which had a difficult quarter, losing 16% on August 5. Bristol announced that its immuno-oncology drug Opdivo failed a clinical trial in first-line lung cancer treatment. This surprised the market given Opdivo’s track record of successful trials, plus a recent successful trial for a competitor drug from Merck. We view the failed Opdivo trial as the result of the way the trial was designed, as opposed to a shortcoming in the drug itself. While this is a significant near-term setback, Bristol remains well positioned to lead the immuno-oncology market. Looking further out, we expect the treatment of lung cancer to evolve from individual drugs to combinations, where Bristol is poised to regain the advantage.
Financials — In the financials sector, our Indian holdings Housing Development Finance Corporation and HDFC Bank rebounded over the quarter, returning 13.9% and 9.6% respectively. Together the holdings represent over 7% of the portfolio. However, their positive performance was overshadowed by our holding Wells Fargo, whose stock declined significantly since it was announced in early September that the company had reached a $190 million settlement with the regulators because some of their employees had opened accounts for clients without the clients’ authorization. Employees that were engaged in these unauthorized account openings were let go by the company when the management became aware of what took place. A key point of this case is that we see the unauthorized account opening as a failure of compliance oversight internally. As the company made little income from these activities, the primary benefit appears to have been to employees in reaching performance goals. As a result, we feel it was a genuine oversight by management as opposed to an encouraged or tolerated practice designed to profit the bank at the cost of customers.
In our opinion, the amount of the fine is small at $190 million compared to the company’s net income that is running at over $20 billion a year. Our main concern is whether this will have a lasting reputational damage to the company. While we believe Wells will remain under the spotlight over the coming few weeks, we do not feel, at this point, that the unauthorized account opening problem will have a material impact on customer behavior. As a result, we do not anticipate the bank’s long-term earnings or value have been damaged despite the negative headlines. We remain holders of Wells Fargo. The company’s shares are trading at a price-to-earnings (P/E) discount to its regional bank peers and it offers an attractive dividend yield of 3.5%. We are monitoring developments closely, including the Department of Justice’s investigation of the situation. We may react to any further developments if we have reason to believe the sustainability of Wells Fargo’s franchise will be potentially impacted over the longer term.
We believe Wells Fargo has been one of the world’s best-run major banks. The company’s management has steered a sensible lending business that remained on a solid financial footing throughout the 2008-2009 banking crisis. It has a very strong core deposit franchise and benefits from economies of scale. The bank is expected to earn a return on tangible equity of about 14% this year, among the highest in the industry.
Progressive Corporation, which we sold over the quarter, also detracted from returns.
Information Technology — Our IT holdings contributed to returns. Specifically, MasterCard and Alphabet were top performers. MasterCard posted solid second quarter results, supported by strong pricing and the delivery of new services. The stock outperformed as it saw solid processed transaction and cross-border volume trends driving a slight upward revision to FY16 guidance to low double-digit revenue growth. MasterCard continues to gain market share in consumer debit, commercial, and prepaid segments. We are positive on the company’s acquisitions in the automated clearing house (ACH) space, such as Vocalink, which allows access to new payment flows, better customer engagement, and expanded payment ecosystems. MasterCard and PayPal also announced an expanded partnership, aimed at enhancing the consumer experience at each company.
Alphabet’s share price was strong leading up to announcing its second quarter results and soared after releasing earnings that exceeded consensus expectations. The company’s results were supported by solid revenue growth, driven by mobile advertising and YouTube, and paid click growth. Operating margins rose due in part to operating leverage on the cost side. We believe Alphabet continues to be a good value, with the cash component and YouTube business not priced in at current levels.
Consumer Discretionary — In the consumer discretionary sector, Amazon continued to reach new highs as it exhibited strong results, contributing to performance. In North America, revenue growth accelerated to 28% in the second quarter, while international growth picked up to 30% year-over-year. We believe the main reason is the success of Amazon Prime, which is driving higher frequency of ordering, higher transaction value, and lower churn. We are also seeing better-than-expected margin expansion, due to a higher contribution of sales from third-party products, which is also being fueled by increasing availability on Prime and FBA (fulfilled by Amazon). Finally, Amazon Web Services' (AWS) revenue growth has continued to remain strong at 58% and operating margins at a record 30%. Overall, Amazon’s operating leverage and margin expansion story are now becoming more evident, even after allowing room for further investment to strengthen its competitive advantage.
No Weighting — Our lack of exposure to utilities and telecommunication services also added to relative returns.
While the Fund’s portfolio represents the broadest geographic exposure, it is not simply a conglomeration of all the underlying geographic strategies since it is managed in a very concentrated style. We usually initiate positions in our regional strategies first. Consistent with this approach, four of the seven new positions we initiated this quarter — Alibaba, M&T Bank, Casey’s General Stores, and Starbucks — were names previously held in our regional strategies that, based on our in-depth research, warranted more exposure.
Alibaba (Information Technology) — Internet names continued to surprise on the upside this quarter, driven by social media advertising. In China, the tailwind from e-commerce and mobile commerce penetration is still in its relatively early stages. We took the opportunity to capitalize on this trend and purchased Alibaba, China’s leading e-commerce platform operator, for the portfolio. Alibaba enjoys dominant market share based on overall gross merchandise volume (GMV), which is significantly larger than JD.com, the second biggest player in China. In our view, Alibaba’s key competitive advantage is that it has a significant number of vendors, which attracts a massive pool of buyers. Alibaba provides its customers with access to the widest available inventory at the most competitive prices in almost any category. Other markets, such as Japan and the U.S., have shown us that it is difficult to displace a company with such a significant supplier/merchant advantage. Alibaba’s shares soared this quarter after it delivered FY1Q17 results that exceeded consensus expectations. China retail revenue — the pure e-commerce segment — grew 49%, on the back of GMV growth of 24%, the fastest revenue growth since the company’s IPO in 2014. Growth has been driven by an improvement in Alibaba’s monetization rate, with mobile monetization now marginally overtaking PC at 2.8%.
M&T Bank (Financials) — In the financials sector, we have found that regional banking companies are better positioned than large global, investment banking operations. As such, we added Buffalo, New York-based M&T Bank this quarter, which we initially held in our U.S. strategy. M&T Bank is a commercial and retail bank operating in several northeastern states in the US. We believe it has achieved some of the most consistent and high returns of any U.S. banks. Its conservative and skillful loan underwriting has long been a hallmark of the firm and has manifested itself in below-average charge-offs over multiple credit cycles. In addition, we believe the company has enjoyed superior profitability because of its low funding costs (due to strong local market share and tight expense controls), with industry-leading efficiency ratios. M&T Bank further enhanced shareholder returns through value-added opportunistic acquisitions.
Casey General Stores (Consumer Staples) — We continue to maintain our overweight to the consumer staples sector. We purchased Casey’s General Stores, a convenience store operator located in the Midwestern U.S. Casey’s maintains a dominant distribution infrastructure without requiring high capital expenditure spending. Despite softer-than-expected results, the company has maintained its annual guidance for fiscal 2017. We remain confident in its ability to deliver based on a strong store footprint and business franchise and a solid management track record.
Starbucks (Consumer Discretionary) — A well-recognized global brand that implies quality products and a quality experience, Starbucks has an extremely strong footprint in the U.S. China also represents a significant growth opportunity. While beverages constitute about 75% of revenues, food has grown to represent 20% of sales, and the company has high aspirations for its own consumer products group. Starbucks generates strong free cash flow, which it has used to increase its dividend and repurchase shares.
Anheuser-Busch InBev (ABI) (Consumer Staples) — ABI is the world’s largest brewer that dominates the beer market in most of the countries in which it operates. Globally, it has roughly one fourth of beer volumes and close to one half of global beer profits. We believe ABI is best-in-class on costs, among consumer staples companies, not just brewers. Synergies should result from combining the SABMiller-ABI businesses, such as a sales increase from distributing ABI’s global beer brands (Corona, Stella Artois, and Budweiser) through the legacy SABMiller distribution in faster growing emerging markets. While we typically shy away from large acquisitions, ABI’s management team has historically executed extremely well on its acquisitions, being prepared before deals close with many of the important decisions needed for a smooth integration. Once SAB is digested and the debt reduced, ABI is likely to generate high levels of free cash and will either decide to do another accretive acquisition or return large amounts of cash to shareholders, either of which, in our view, would be beneficial to shareholders. (For more on our view of ABI, see the "Investment Case Study" at the end of this commentary.)
SABMiller (Consumer Staples) — SABMiller in our view is the best positioned global brewer for long-term growth. We owned it previously in the Fund, and bought it back this quarter after the Brexit vote, when we felt that either ABI would need to increase its bid for SAB or SAB would remain independent. While we preferred SAB remaining independent, the deal did get voted through after ABI increased its bid.
Dollar Tree (Consumer Discretionary) — Dollar Tree's stock came under pressure over the quarter, leading to our decision to buy more shares at what we considered a good value. Dollar Tree, a U.S.-based company that operates in the discount retailing sector, sells its merchandise at a lower price point than other “dollar stores.” With a strong management track record, there is room for company expansion into the west coast and southern regions of the U.S. Dollar Tree’s second quarter results showed a sales increase of 66% to $5 billion, including $1.8 billion in incremental sales from its recent acquisition of Family Dollar, from which we expect to see synergy benefits.
We exited three positions over the quarter — CME Group Inc., Progressive Corporation, and Apple — in order to reallocate that capital to better opportunities for this concentrated portfolio.
Separately, in the health care space, we reduced our weights in Roche and Celgene.
PERSPECTIVE & OUTLOOK
Our Valuation Discipline
Regardless of the market environment, we uphold our rigorous philosophy and process that focuses on identifying high quality businesses around the world. We own a concentrated collection of businesses that are strong franchises with good economic returns and prospective earnings growth potential. While uncertainty persists from quarter to quarter, either driven by specific events or a difficult macroeconomic environment, we continue to focus on being very selective in adding new names and reallocating capital among our names.
We believe we have a strong valuation methodology that is predicated on our ability to invest in companies where we can accurately forecast sustainability of long-term earnings and dividend growth potential, while paying what we believe is a sensible price relative to our estimate of the fair value. There are three reasons that cause us to sell a stock: 1) a deterioration in the fundamentals of a business as we believe the stock prices of companies with declining earnings can be harshly punished in uncertain markets, 2) a stock price reaches our estimate of intrinsic value, or 3) a significant event, such as M&A activity, results in a change to our investment thesis.
In many sectors, P/E ratios are now toward the high end of their historic ranges and can reverse as interest rates rise. We are cognizant of this environment and evaluate the P/E of each of our holdings relative to its own history. Over the course of this year, and even in the third quarter, we trimmed back some positions that had appreciated and gotten closer to, or reached, our price targets.
While we scaled back some positions in the portfolio, we increased exposure to others. One notable change over the quarter is that we further added to our U.S. and Chinese e-commerce exposure. Our Chinese exposure does not reflect a top-down view on China, rather a deepening of our conviction of the long-term growth potential of the leading Chinese e-commerce companies: Alibaba and Tencent. We increased exposure in businesses that we believe will deliver reasonable levels of returns and growth, even with a slowing macroeconomic environment in China. But, by and large, our sector weightings haven’t changed significantly from last quarter. For example, we continue to maintain our meaningful overweight to the consumer staples sector.
Calm Before the Storm?
Over the third quarter, equity investors saw generally low volatility and positive markets globally, a stark contrast to the sharp declines that rattled markets last August. This has partly been a result of the slowdown during the summer months, but also due to investors’ anticipation of changes in global monetary policy. We would not be surprised to see market nervousness pick up as we move into the last few months of the year.
We caution investors that, given our consistent focus on investing in high quality growth companies for an absolute return, we will often underperform the market during market upswings, as occurred this quarter. Looking into the fourth quarter, relative performance could suffer from continued flows into cyclical areas or a further appreciation in oil or commodity prices.
U.K. equity markets performed well in the three months after the initial shock of the U.K.’s decision to leave the European Union (EU). Since the vote, most of the data coming out of the U.K. has been fairly positive, which we see as a calm before a storm. The formal process of leaving the EU has not yet started. When negotiations start, we feel there could be a rise in bitter EU/U.K. rhetoric that could shake European and U.K. market confidence at times until a final exit package is established.
This could provide a difficult backdrop for the European banking system to sort out its long festering problems. As a result of these issues, as well as a number of national elections including France and Germany, we do not expect, or look for, strong demand growth across Europe over the coming year or two to drive earnings growth within the portfolio. We therefore are largely invested in companies that have drivers separate from low-growth European GDP.
We are closely watching U.S. monetary policy and its potential impact on emerging markets. Higher interest rates in the U.S. generally create headwinds for emerging markets, making their assets relatively less attractive to investors seeking yield. We are concerned about the Fed’s impact on emerging markets countries with weak current account deficits and budget deficits, such as Turkey and South Africa.
We maintain exposure to India across our portfolios. India has benefited from low commodity prices as a net importer, but also from the sensible economic reforms the BJP government is slowly enacting alongside a steady hand at the central bank. India has a number of high quality and dominant listed companies, but is also a difficult market for new competitors as barriers to entry are often high. For businesses on the inside of these barriers, the outlook can be attractive and offer a long runway of growth, given the early stage of India’s consumption. The other benefit from investing in India is its diversifying effect. We believe the outlook for our holdings in India is minimally impacted by China’s investment cycle or commodity global reference prices, if at all.
In Brazil, President Dilma Rousseff was impeached in August, clearly an important political development. The Senate voted 61 to 20 to convict Ms. Rousseff on charges of manipulating the federal budget in an effort to conceal the nation’s mounting economic problems. Michel Temer, the interim president who served as Ms. Rousseff’s vice president, has set an aggressive agenda for budget control and investment infrastructure. We are positive on the direction of the economic policy; yet cautious because those measures still need to be approved by Congress and the economy is still working through a deep recession. While Brazilian equities rallied this quarter in the midst of hope and euphoria, realistically, there are still some painful financial measures that need to be put into effect. We do believe the economy should improve in the long run, but the turnaround in Brazil will be slow.
As bottom-up investors, the quality of the franchises we own and their ability to deliver is paramount to our investment process. While some businesses we own have come under pressure, we are confident in our portfolio holdings and their ability to deliver high single-digit to low double-digit earnings growth over time. And, through our in-depth, fundamental research, we continue to find new opportunities.
INVESTMENT CASE STUDY
Our View: Anheuser-Busch InBev Takeover of SABMiller
On July 29, SABMiller’s (SAB) board approved an increased cash offer by Anheuser-Busch InBev (ABI) of £45 per share. On September 28, SAB shareholders backed the takeover by ABI, laying the foundation for one of the biggest corporate mergers in history. We voted against the deal.
We have been long-term investors and at 3Q16 quarter-end, across our strategies, held over 1% of the outstanding shares in SAB. We invested in SAB well before ABI’s attempt to purchase the company. It is our opinion that as a standalone company SAB is capable of delivering attractive returns to shareholders for decades to come, driven by low- to mid-teens earnings growth and a healthy dividend. Not only is this a highly unusual company in terms of potential growth, but it is also rare given the predictability of its business. In a recession, demand for cars or new homes may fall, but beer sales historically remain stable.
As the world’s second largest brewer, SAB has dominant market positions in countries where per capita consumption of its beverages are extremely low. The company operates in more than 80 countries, with close to 70% of its earnings in the last year coming from developing markets where, as the middle class develops, we expect rapid growth in demand for the company’s products alongside a demand for higher-margin premium beer. In Colombia, for example, its market share is above 90%, in a country where per capita beer consumption is a third lower than Brazil, which itself is still growing. And in Sub-Saharan Africa (excluding South Africa), per capita consumption is just a small fraction of Colombia’s low level. We see decades of beer consumption growth ahead in many of its geographies, especially those in Latin America, Africa, and Asia.
Nothing in the takeover price reflected these realities. Worse: As a result of the surprise Brexit vote and due to its London listing, the value of the offer in pounds sterling fell sharply in U.S. dollar terms between the time the deal was first announced and the time shareholders will receive their cash. As SAB generates roughly 98% of its revenue outside the U.K., the value of the business has been largely unaffected by sterling’s fall. Thus, the valuation of the deal became even less attractive. Furthermore, the value of other consumer staples stocks has expanded, while SAB’s was been held back by the cash offer.
In October 2015, SAB’s board rejected the third offer from ABI of £42.15 saying it “very substantially undervalues SABMiller.” Both on a price-to-forward earnings and enterprise value (EV)/forward EBITDA basis, the current cash offer is worse than the original offer, which was by the board’s admission very substantially undervalued.
While we think the SAB board made the right decision to recommend to the court to view its shareholders as two separate classes, we still think that it has made a misstep by accepting this insufficient offer. Since the deal was first announced, there have been changes in currency, rising valuations for consumer staples companies and rising underlying earnings at the company, none of which has been taken into account. We strongly believe the long-term trajectory of a standalone SAB was extremely attractive.