Virtus Global Opportunities Fund
4Q 2016 COMMENTARY
Global equities withstood a multitude of shocks in 2016. Despite economic and political uncertainty weighing on markets at times, bullish sentiment in the U.S. strengthened throughout the year. Risk aversion dominated markets early in the year as investors contemplated falling oil prices, slower growth in China, and changing U.S. Federal Reserve monetary policy. By the second quarter, encouraging economic data and supportive central bank policies strengthened U.S. and European equities, although the United Kingdom’s vote to exit the European Union eclipsed other developments. The Brexit vote was followed by a sell-off in global risk assets and a sharp decline in the British pound against its major trading currencies.
Global equities recovered rapidly from the Brexit sell-off, and high quality stocks participated in the rally. Equity markets responded positively to continued loose monetary policy in developed markets, as well as OPEC’s tentative agreement to cut production. And, equity performance of key emerging markets, such as China, Brazil, Korea and Taiwan strengthened. Shortly thereafter, however, sentiment changed and began to reflect a belief that the benefits of expansionary monetary policies had been exhausted. This change in views spurred a rotation into cyclicals and financials and out of consumer staples, telecommunications services, and utilities, a rotation which continued through the end of 2016. In the fourth quarter, Donald Trump’s surprise victory in the U.S. presidential election sparked a reflation rally in the U.S. and most developed markets, driven by his promises to implement pro-business polices and fiscal stimulus.
In general, the pro-business aspects of Trump’s platform—lowering taxes, reducing regulation, and boosting infrastructure spending—are aimed at stimulating economic growth. If successful, they could result in higher inflation, as well as higher interest rates. U.S. and European banks, long laboring in low and even negative interest rate territory, rallied in anticipation of higher earnings in the form of net interest income and loan growth.
During the quarter, emerging markets came under pressure. Concerns about rising interest rates, a stronger U.S. dollar, and potential changes to U.S. policy resulted in significant capital outflows from emerging markets, and renewed concern about dollar-denominated debt. The Federal Reserve increased its benchmark rate for the second time in a decade during December, which became an additional source of apprehension.
A weak euro may prove to be a boon for exporters in some European nations. However, European equities finished the period slightly negative against a backdrop of political uncertainty. The European Central Bank (ECB) announced its intention to continue quantitative easing through 2017, although it will begin to taper in April.
In the fourth quarter, a confluence of events created headwinds to our high quality style resulting in the the Fund’s negative performance. The difficult environment led us to give back returns that the strategy had generated in the first half of 2016, underperforming the benchmark MSCI All Country World Index (ACWI) while still ending the year in positive territory.
In the second half of the year, market sentiment bolstered risk assets. Our performance was driven by this strong momentum away from quality names, rather than a deterioration in the fundamentals of our portfolio holdings. In fact, this year many of our companies continued to deliver earnings growth in-line with our expectations and consistent with that of previous years. Where there were issues with either growth or valuations, we adjusted holdings accordingly.
The consumer staples sector was the largest detractor from fourth quarter performance, resulting from the market rotation out of quality. The Fund’s consumer staples holdings performed in line with the consumer staples sector of the MSCI ACWI; however, our large overweight to staples was the main contributor to the negative performance. British American Tobacco and Reckitt Benckiser were two of our larger portfolio holdings that underperformed.We have long held a significant overweight to staples companies due to our bottom-up focus on high quality growth franchises with deep moats. While investors who view staples as defensive or a dividend play rotated out of the sector, as a buy and hold asset manager, we continue to view staples as an attractive sector. Demand for products that staples companies sell is not economically sensitive. We are able to find staples companies with earnings derived from a broad set of geographies and products, which helps reduce risk to the underlying earnings stream within our portfolios. And, we believe many staples companies have strong brands which results in superior profitability.
Our holdings in the consumer discretionary sector underperformed those of the Index. Specifically, although Amazon’s revenue growth came in at the high end of guidance (29% year-over-year), the firm guided to a slowdown in the fourth quarter to 22%. Operating margins also came in below expectations due to investment in fulfillment centers, content, and international business lines. We are comfortable with these investments as they make Amazon’s platform “stickier”. We have seen evidence of this over the last two years as Amazon’s revenue accelerated after its investment in Prime service.
Our lack of exposure to the energy sector also detracted from relative performance as OPEC’s agreement to its first oil production cuts in eight years led to a rally in energy producers.
The Fund’s financials holdings performed positively, although our lack of exposure to certain names in the sector (JPMorgan Chase, Bank of America, Citigroup) hurt relative performance as these firms rallied over the quarter. From an absolute standpoint, our U.S. financials holdings Wells Fargo, M&T Banking Corporation and Berkshire Hathaway all performed well. We think U.S. banks could see higher earnings due to several factors: higher rates, and a steepening of the yield curve leading to greater net interest margins, lower taxes, greater GDP growth driving more lending, and less regulation. (See Investment Case Study: “U.S. vs. European Financials: Examining the Post-Election Rally” later in this commentary.) At this time, we do not have exposure to any developed market financials outside of the U.S.
Flows out of emerging markets in the quarter impacted our holdings that had performed well and added to returns earlier this year. For instance, there was a pullback in our long-held Indian financials Housing Development Finance Corporation and HDFC Bank. Their share prices came under pressure from the reversed fund flows from emerging markets back to developed markets in the quarter. In addition, the impact from India’s currency reform led to market uncertainty about broad economic activity. However, we believe these specific reforms in India will be a benefit to these holdings over the medium and long term as the formal economy grows and some of the traditional cash savings are encouraged into the banking system as deposits. Our two Chinese eCommerce holdings, Alibaba and Tencent Holdings both underperformed the benchmark. Alibaba’s share price came under pressure due to a broad sell-off in the Internet sector; we do not see a meaningful change in Alibaba’s fundamentals. Tencent, a major Internet platform in China, reported third quarter results that exceeded expectations in revenues but were in line with consensus in net income; and a slowdown in gaming was offset by better advertising metrics. Our Mexican holding, Fomento Economico Mexicano (FEMSA), detracted from returns. While there may be short-term volatility in its share price and a weakened peso stemming from Trump’s immigration and anti-trade rhetoric, we are comfortable holding companies like FEMSA. The company operates OXXO, Mexico's largest and fastest growing convenience store chain, is a 48% owner of Coke FEMSA, one of the largest Coca-Cola bottlers in the world, and has 20% ownership of the global brewer Heineken. We believe FEMSA is a powerful franchise and an enduring growth business that is consistent with our longer-term investing view.
The biggest contributors to returns were our holdings in the health care sector. United Healthcare, a diversified health care company, provided 2017 guidance ahead of consensus expectations at 18% growth (ahead of long-term guidance of 13% to 16%) with strong enrollment growth for its Medicare Advantage plan, as well as fewer headwinds from losses from the Affordable Care Act. Our holdings Celgene Corporation,which we exited,and Bristol-Myers Squibb also contributed to relative portfolio results.
Our holdings in the materials sector also added to portfolio performance, benefiting from the possibility of increased infrastructure spending. Martin Marietta was up 24% over the fourth quarter.
Over the course of 2016, we notably increased the Fund’s weight in consumer discretionary stocks and added to our positions in consumer staples. At the same time, we reduced our exposure to health care. With the backdrop of a potentially stronger U.S. economy boosting consumer discretionary spending and market concerns about limits on drug prices in the U.S., we believe these changes will benefit the strategy.
Over the fourth quarter, we added U.S.-based regional bank PNC Financial Services Group (PNC). PNC is a conservatively managed asset-sensitive bank whose earnings power and net interest margin have been under pressure in recent years because of the unusually low level of interest rates. We expect PNC’s earnings power to be a direct beneficiary of any rise in rates that the Federal Reserve has in store for us in 2017. Furthermore, PNC has had a modest amount of its portfolio exposed to the oil and gas sector and had been increasing its reserves against these assets over the last several quarters. However, the recent rise in oil prices means that the majority of energy-related credit pressures the bank experienced in 2015 have largely subsided and, in the recent quarter, nonperforming energy loans decreased as did PNC’s provision for energy credit losses.
We also added Mexico’s Fomento Economico Mexicano SAB (FEMSA), a long-term position in our Emerging Markets Equity Strategy. FEMSA is the leading beverage company in Latin America. FEMSA has long-term growth opportunities based on stable consumption trends, market share gains, pricing power, and scale. The company has a deep history managing through currency and debt crises, a strong balance sheet, and the ability to finance itself with local as well as foreign denominated debt.
We added to our existing position in Anheuser Busch Inbev (ABI). ABI dominates the beer market, with roughly one-fourth of beer volumes and close to one-half of beer profits globally. With the combined ABI/SABMiller (SAB) business, it is now more exposed to faster growing markets. This should lead to both fast top- and bottom-line growth and a sales increase from using the legacy SAB distribution in emerging markets to sell ABI’s global beer brands. Once SAB is digested and the debt reduced, ABI is likely to generate high levels of free cash flow and will either do another accretive acquisition or return large amounts of cash to shareholders, either of which would be beneficial to shareholders. Although currently several of its markets, such as Brazil and Mexico, are going through rough patches, longer-term, this dominant franchise should remain strong.
INVESTMENT CASE STUDY
U.S. vs. European Financials: Examining the Post-Election Rally
In the U.S., financials have led the rally following Trump’s election victory in early November. A key reason has been a spike in long-term interest rates supported by expectations that Trump’s fiscal policies of lower taxes and increased infrastructure spending would lead to faster nominal growth. Higher interest rates should benefit banks’ net interest margins, which have been contracting for several years in an ultra-low rate environment. We expect regional banks to be the biggest beneficiaries as they derive the bulk of their earnings from spread income.
Investors also anticipate a looser regulatory environment under the Trump administration. While an outright repeal of Dodd Frank is unlikely, it is expected to be substantially watered down. For instance, the threshold for the minimum asset size that subjects a bank to annual stress tests is likely to be raised from the current $50 billion level to at least $100 billion, and possibly $250 billion. This would lessen the burden on mid-sized regionals and especially help those approaching the heretofore critical $50 billion mark. There is also a good possibility that the Volcker rule would be eliminated, although investment banks have already closed their proprietary trading desks and are not likely to resurrect them even if the Volcker rule is abolished. We also expect the Consumer Financial Protection Bureau (CFPB) to become less aggressive than it has been recently, a welcome development for consumer-focused financial institutions.
Finally, the Trump administration is likely to propose reducing the tax rate for all U.S. corporations. We expect U.S. banks to benefit more than others because they have high effective tax rates as U.S.-based banks have not been able to take advantage of the various schemes that shift where profits are booked to low-tax jurisdictions. One area to watch on the tax front is the possible change to the tax deductibility of interest payments. A plan offered by House Republicans would render interest payments no longer tax deductible. If this were implemented, it is likely to apply to interest payments on debt but not on bank deposits (i.e. depository institutions should be carved out). Though specific bills have yet to be written and thus it is an area to monitor as it would affect the degree to which banks may benefit from lower tax rates.
The U.S. financial sector has outperformed based on expectations of favorable developments that appear to be fairly likely. Our holdings such as Wells Fargo, M&T, and PNC have participated in the rally as well. While many financials have finally re-rated in the past two months (after a long period of lackluster performance, weighed down by low interest rates and a tough regulatory environment), the high-quality financials we hold are still attractively valued, in our view.
In Europe, many financials have also done well in the latter part of 2016. One reason for this is slightly higher long-term interest rates (based on marginally stronger economic news and expectations for a less aggressive quantitative easing). This is positive for banks’ net interest margins. In addition, some European investment banks (e.g. Deutsche Bank, Barclays) have substantial U.S. subsidiaries which are presumed to benefit from the expected regulatory relief in the U.S. The smaller-than-feared fine imposed by the Department of Justice on Deutsche Bank (for misselling mortgage-backed securities prior to the financial crisis) has also helped to assuage investors’ concerns that the worst is probably over in terms of severe penalties for misdeeds that occurred in the years leading up to the financial crisis.
While the developments described herein are helpful to a number of European banks, it is important to keep in mind that, as a group, they are still not earning their cost of equity. Most European banks will not be able to earn a double-digit ROE this year or next year. Furthermore, there are substantial political risks in the coming months (e.g., the French election) to which banks are particularly vulnerable. Finally, loan growth is de minimis in most European countries.
Thus, while it would be positive for banks if interest rates have indeed bottomed out, there are many other reasons for quality managers to avoid broad exposure to European financials. But, despite the recent rally, we will continue to adhere to our investment discipline and remain very selective, as most European financials do not meet our quality standards.
Over the quarter,we sold SABMiller Limited as it was purchased by ABI. We also exited Cognizant Technology Solutions due to the recovery of its share price off of recent lows and its current valuation compared to reasonable expectations of growth. Additionally, due to the increasing risk of a negative effect from immigration reform in the U.S. on its business, we chose to reallocate capital to better opportunities.
We sold Celgene after the stock rallied significantly post the U.S. election. Current fundamentals remain robust with greater than 20% revenue growth and its existing drug portfolio has a long runway before meaningful patent expirations. However, due to lower visibility in its potential earnings growth over the long term and a recovery to more reasonable valuations, we decided to sell the stock.
THE IMPORTANCE OF PERSPECTIVE
We believe it is helpful to look at the Fund's performance from a broader perspective, and compare short-term returns with longer-term excess returns. Short-term performance is heavily influenced by valuation, one of the three main drivers of returns, while earnings growth and dividends have less effect. Over longer observation periods, earnings growth and dividends have a greater influence on total shareholder return. The chart below compares excess returns of the Fund against the MSCI ACWI for both 3-and 36-month rolling periods. Looking at the Fund's track record of excess returns, it is apparent that we have gone through a number of periods of underperformance, but over 3-year rolling periods, the Fund's excess returns have been considerably more consistent than during the shorter periods, resulting from solid performance from the underlying holdings. This distinction we feel is key. We look to outperform the market with less volatility over a full market cycle, and short-term underperformance during times of market optimism are part of our investment profile, albeit at times painful. We maintain conviction in our quality style of generating alpha by investing in steadily growing companies that compound earnings over long time periods.
ADDRESSING PERIODS OF UNDERPERFORMANCE: 2009, 2013, AND TODAY
Late in the first quarter of 2009, fears of economic depression dissipated after the global financial crisis, equity markets rallied, and investors preferred the shares of more highly leveraged and cyclical companies throughout much of the year. Even when there was a significant disparity between the anticipated operating performance of these companies and their relative share performance, investors remained optimistic. Meanwhile, shares of higher quality, more stable companies, which had lost less ground when investors’ fears were peaking, appreciated but underperformed on a relative basis.
In 2009, U.S. Fed Chairman Ben Bernanke signalled that the Fed would “taper” quantitative easing, which while initially seen as a negative in terms of withdrawing support for providing ultra-loose monetary policy to support growth, came to be seen as a positive throughout the year because the economy showed signs of improvement. From the announcement in May 2013, the U.S. market was up 13% through year-end 2013. Financials, on the perception of future rate/yield rises, outperformed the S&P 500® while consumer staples lagged. Europe, on the back of ECB President Mario Draghi’s support, saw similar types of performance during this time period as well, with consumer staples underperforming and financials outperforming. Lastly, there was a rotation out of emerging markets, especially those countries with U.S. dollar-denominated debt exposure and high current account deficits, into developed markets.
Fast forward to 2016 and an environment that is similar to that of 2009 and 2013, where lower quality stocks outperformed. Trump's election, the impending impact of Brexit, and potential inflationary policies have driven long-dated Treasury yields higher. Also, commodity prices have risen on OPEC cuts and infrastructure growth speculation. The result has been a rotation from sectors perceived as bond proxies (consumer staples, telecommunication services, and utilities) into cyclicals and financials.
2017 OUTLOOK: FOCUS ON EARNINGS AMID UNCERTAINTY
We believe the global economic recovery will continue in 2017. Developed economies are likely to continue strengthening, albeit slowly. Since the 2008 financial crisis, developed economies have benefited from the extraordinary measures undertaken by major central banks and the healing that comes from the passage of time. The U.S. economy remains on especially solid footing. Real GDP is expected to rise from around 1.6% in 2016 to more than 2.0% this year. Importantly, labor conditions have noticeably improved—the unemployment rate has declined to a nine-year low—and inflation is now moving towards the Fed’s 2.0% target (Source: Bloomberg). Prospects for the eurozone, however, are less robust, where a number of banks continue to restructure, and it is difficult to isolate how much of the current recovery across the periphery nations is underwritten by the ongoing quantitative easing from the ECB. Thus, even if the Federal Reserve tightens policy further this year, as expected, the ECB and Bank of England are unlikely to withdraw monetary accommodation anytime soon with the looming confidence risks of the Brexit negotiations kicking into gear and upcoming elections in France (April 2017) and Germany (second half of 2017).
Equity markets have rallied since the U.S. election and are looking for Trump’s administration to launch a number of initiatives designed to accelerate growth of the U.S. economy and bring income growth back to the middle classes. While this optimism may be warranted, we are cautious about the U.S. equity market getting too far ahead of itself and underappreciating potential risks, particularly in regards to timing.
This paradigm shift presents new challenges for global investors. For several decades, investors have become accustomed to a constant direction in the world economy, led by the U.S. and other developed markets outsourcing production to lower cost emerging market-based companies. Any shift in the U.S. position on trade direction is likely to have a magnified impact on global supply chains and, if so, could result in a number of secondary impacts. This naturally would have a bottom-up impact for many companies, particularly those that export to the U.S. as an important part of their business.
Given this uncertain backdrop, we are constantly evaluating and re-evaluating opportunities for sustainable earnings growth driven by what we believe are solid structural drivers. We have rarely found the labor or regulatory arbitrage of emerging market to developed market exporters of lower value-added products attractive and do not hold any companies where this is the primary driver of their earnings. If a company is to export, then we feel a barrier greater than a cheap currency or low wages is vital and look for companies that could stand on their own two feet even if they were located in developed markets, e.g., certain Indian generic pharmaceutical companies that develop and own proprietary intellectual property.
We continue to carry out our rigorous analysis to ensure our existing holdings remain in a position to deliver the long-term growth we seek. We have learned over a number of market cycles that, when the markets are on a cyclical rally, it is important to maintain the discipline of our style and keep focused on long-term earnings, as this is what we believe is the key driver to long-term returns. In the near term, this can lead to market underperformance while valuations fluctuate, but over the long term, we strongly believe earnings growth and dividends are far greater contributors to returns than swings in valuation multiples.