Commentary
The fund had a good quarter, rising by 14.1%. This compares to a rise of 10.4% for the MSCI EAFE index. The rapid shift in interest rate expectations, with the yield of the 10-year US treasury note peaking at 5.0% in mid-October and ending the year at 3.9%, provided a favourable environment for equities.
The two main positive contributors to performance were IWG (+40% in USD) and JD Wetherspoon (+23%). IWG, the serviced office provider, presented a confident outlook at its capital markets day in December. Also, given the company’s real estate end market exposure, it is relatively rate sensitive. JD Wetherspoon, the UK pub group, benefited from strong like-for-like sales growth of 9.5% for the 14 weeks ending 5th November.
The main negative contributors to performance were Alibaba (-10%) and BP (-7%). In an about-face, the management of Alibaba, the Chinese e-commerce company, decided to scrap plans for a spin-off of the group’s cloud business, citing concerns around US export restrictions for cutting-edge chips. While clearly disappointing, the group remains committed to delivering shareholder value, with management recently highlighting that they are targeting double digit returns on invested capital. They are also buying back shares and have recently initiated a dividend policy. Adjusting for Alibaba’s net cash, the shares are trading on a forward price-to-earnings multiple of around 7x. We do not believe that the current price reflects the value of the different assets which includes AliCloud, Cainiao Smart Logistics, and international e-commerce businesses such as Lazada.
BP, the oil & gas company, suffered as oil prices dropped from $95 per barrel in late September to $77 by year-end. In addition, there is some uncertainty around the group’s potential future strategy given that it is not clear yet who will succeed Bernard Looney as CEO. The valuation remains attractive, with a free cash flow yield at 14%.
Annual Portfolio Performance
The fund returned 31.1% in 2023, compared to a return of 18.2% for the MSCI EAFE Index. While 2023 presented market watchers with many grounds for concern (think rising rates, recession fears, US banking crisis, an economic downturn in China), the fund’s holdings delivered fundamentally, with aggregate earnings per share growing by over 20%. The annual return is almost entirely explained by earnings growth and dividends, with the fund’s forward price-to-earnings ratio re-rating by just 5% to now 9.0x.
The main positive contributors to returns were JD Wetherspoon (+92%) and two of the fund’s financial holdings: Fairfax (+59%) and Alpha Services (+59%). Similar to the Q4 performance discussed above, JD Wetherspoon benefited from strong trading throughout the year. Despite a recovery in the business, however, the company still trades at a price-to-book multiple of just half of pre-Covid levels. We were pleased to see that the company’s Board also recognises the disconnect between price and value and executed a share buyback program equal to 2.9% of the outstanding shares in December.
Fairfax, the Canadian insurer, has benefitted from rising interest rates. Under the savvy management of Prem Watsa, they entered the rising rates cycle of 2022 with a low-duration book. This helped to minimise mark-to-market losses on its bond portfolio. Moreover, throughout 2023 the company was then able to extend the duration of its bond portfolio to 3.1 years at an average yield of 4.9%. Bonds now account for 57% of the group’s investment portfolio, up from 28% at the end of 2021. The insurance operations are also performing well, with the combined ratio over the first nine months of 2023 at 94% and a hardening reinsurance market. Going forward, driven by rising returns, the company should be able to generate over $3bn in operating income per year for the next three years, implying a price-to-earnings ratio of around 9x. On a price-to-book basis, the current valuation is at 1.0x, although this is not fully comparable to the past. Recent changes in accounting rules led to a 16% increase in book value per share. Hence, using the old accounting methodology, today’s price-to-book may be closer to 1.2x. With the shares having re-rated from a severely depressed 0.7x price-to-book two years ago, we have reduced the position size. We continue to hold the company given the positive market backdrop and Fairfax’s excellent track record in insurance underwriting and investment, resulting in almost 18% annual book value per share growth from 1985 to 2022.
Alpha Services, the Greek Bank, was another major contributor in the year. Entering 2023, market expectations for the company were very low, reflected in a price-to-tangible-book multiple of just 0.4x. However, confidence in the bank’s prospects then benefited from positive election results in Greece, giving the conservative New Democracy party a second four-year term. New Democracy has governed Greece competently and made it an almost normal economy, with unemployment now at 11% (down from a peak of 28%). In response to structural and budgetary reforms, S&P has upgraded the country to Investment Grade in October. It is not just the economic outlook that has improved. Alpha has continued to reduce non-performing exposure to now 7% and they also target the resumption of dividend payments . At its June capital markets day management laid out a plan to generate returns on tangible equity of above 12% by 2025. They also expressed a preference for returning excess capital to shareholders. The company targets a CET1 of 13%, with excess capital expected to amount to €1.4bn by 2025 – equivalent to almost 40% of today’s market cap. Even after a strong year, we believe the valuation remains attractive at just 0.5x price-to-tangible-book.
The main negative contributors to returns were LG H&H (-12%) and Alibaba (-11%). The performance of both is related to the Chinese consumer. Much of Alibaba’s performance in the year is related to the issues we covered above in our commentary for the fourth quarter. LG H&H, the Korean consumers goods firm, is a relatively recent purchase and we wrote about it in detail in the fund’s July 2023 letter. The main reason for its weak performance is the lack of a post-Covid recovery in its cosmetics business. At current levels the cosmetics business accounts for around 40% of group sales, with the main end market being China. Cosmetic sales in Q3 2023 were still 41% below Q3 2020 levels although Chinese lockdowns are over and Chinese travel to Korea is slowly resuming. Many international cosmetics brands are experiencing the same problem, suggesting that the issue is not LG H&H specific. Perhaps there is a delay in Chinese buying activity or preferences have changed – we cannot be certain. However, we believe that there is a large margin of safety. The fund purchased the preference shares of LG H&H which are trading on a price-to-earnings multiple of just 7x using 2024 consensus earnings, a 55% discount to the company’s ordinary shares. At current levels we believe we can generate double digit returns even without a recovery in cosmetics.
Commentary
The fund had a good quarter, rising by 14.1%. This compares to a rise of 10.4% for the MSCI EAFE index. The rapid shift in interest rate expectations, with the yield of the 10-year US treasury note peaking at 5.0% in mid-October and ending the year at 3.9%, provided a favourable environment for equities.
The two main positive contributors to performance were IWG (+40% in USD) and JD Wetherspoon (+23%). IWG, the serviced office provider, presented a confident outlook at its capital markets day in December. Also, given the company’s real estate end market exposure, it is relatively rate sensitive. JD Wetherspoon, the UK pub group, benefited from strong like-for-like sales growth of 9.5% for the 14 weeks ending 5th November.
The main negative contributors to performance were Alibaba (-10%) and BP (-7%). In an about-face, the management of Alibaba, the Chinese e-commerce company, decided to scrap plans for a spin-off of the group’s cloud business, citing concerns around US export restrictions for cutting-edge chips. While clearly disappointing, the group remains committed to delivering shareholder value, with management recently highlighting that they are targeting double digit returns on invested capital. They are also buying back shares and have recently initiated a dividend policy. Adjusting for Alibaba’s net cash, the shares are trading on a forward price-to-earnings multiple of around 7x. We do not believe that the current price reflects the value of the different assets which includes AliCloud, Cainiao Smart Logistics, and international e-commerce businesses such as Lazada.
BP, the oil & gas company, suffered as oil prices dropped from $95 per barrel in late September to $77 by year-end. In addition, there is some uncertainty around the group’s potential future strategy given that it is not clear yet who will succeed Bernard Looney as CEO. The valuation remains attractive, with a free cash flow yield at 14%.
Annual Portfolio Performance
The fund returned 31.1% in 2023, compared to a return of 18.2% for the MSCI EAFE Index. While 2023 presented market watchers with many grounds for concern (think rising rates, recession fears, US banking crisis, an economic downturn in China), the fund’s holdings delivered fundamentally, with aggregate earnings per share growing by over 20%. The annual return is almost entirely explained by earnings growth and dividends, with the fund’s forward price-to-earnings ratio re-rating by just 5% to now 9.0x.
The main positive contributors to returns were JD Wetherspoon (+92%) and two of the fund’s financial holdings: Fairfax (+59%) and Alpha Services (+59%). Similar to the Q4 performance discussed above, JD Wetherspoon benefited from strong trading throughout the year. Despite a recovery in the business, however, the company still trades at a price-to-book multiple of just half of pre-Covid levels. We were pleased to see that the company’s Board also recognises the disconnect between price and value and executed a share buyback program equal to 2.9% of the outstanding shares in December.
Fairfax, the Canadian insurer, has benefitted from rising interest rates. Under the savvy management of Prem Watsa, they entered the rising rates cycle of 2022 with a low-duration book. This helped to minimise mark-to-market losses on its bond portfolio. Moreover, throughout 2023 the company was then able to extend the duration of its bond portfolio to 3.1 years at an average yield of 4.9%. Bonds now account for 57% of the group’s investment portfolio, up from 28% at the end of 2021. The insurance operations are also performing well, with the combined ratio over the first nine months of 2023 at 94% and a hardening reinsurance market. Going forward, driven by rising returns, the company should be able to generate over $3bn in operating income per year for the next three years, implying a price-to-earnings ratio of around 9x. On a price-to-book basis, the current valuation is at 1.0x, although this is not fully comparable to the past. Recent changes in accounting rules led to a 16% increase in book value per share. Hence, using the old accounting methodology, today’s price-to-book may be closer to 1.2x. With the shares having re-rated from a severely depressed 0.7x price-to-book two years ago, we have reduced the position size. We continue to hold the company given the positive market backdrop and Fairfax’s excellent track record in insurance underwriting and investment, resulting in almost 18% annual book value per share growth from 1985 to 2022.
Alpha Services, the Greek Bank, was another major contributor in the year. Entering 2023, market expectations for the company were very low, reflected in a price-to-tangible-book multiple of just 0.4x. However, confidence in the bank’s prospects then benefited from positive election results in Greece, giving the conservative New Democracy party a second four-year term. New Democracy has governed Greece competently and made it an almost normal economy, with unemployment now at 11% (down from a peak of 28%). In response to structural and budgetary reforms, S&P has upgraded the country to Investment Grade in October. It is not just the economic outlook that has improved. Alpha has continued to reduce non-performing exposure to now 7% and they also target the resumption of dividend payments . At its June capital markets day management laid out a plan to generate returns on tangible equity of above 12% by 2025. They also expressed a preference for returning excess capital to shareholders. The company targets a CET1 of 13%, with excess capital expected to amount to €1.4bn by 2025 – equivalent to almost 40% of today’s market cap. Even after a strong year, we believe the valuation remains attractive at just 0.5x price-to-tangible-book.
The main negative contributors to returns were LG H&H (-12%) and Alibaba (-11%). The performance of both is related to the Chinese consumer. Much of Alibaba’s performance in the year is related to the issues we covered above in our commentary for the fourth quarter. LG H&H, the Korean consumers goods firm, is a relatively recent purchase and we wrote about it in detail in the fund’s July 2023 letter. The main reason for its weak performance is the lack of a post-Covid recovery in its cosmetics business. At current levels the cosmetics business accounts for around 40% of group sales, with the main end market being China. Cosmetic sales in Q3 2023 were still 41% below Q3 2020 levels although Chinese lockdowns are over and Chinese travel to Korea is slowly resuming. Many international cosmetics brands are experiencing the same problem, suggesting that the issue is not LG H&H specific. Perhaps there is a delay in Chinese buying activity or preferences have changed – we cannot be certain. However, we believe that there is a large margin of safety. The fund purchased the preference shares of LG H&H which are trading on a price-to-earnings multiple of just 7x using 2024 consensus earnings, a 55% discount to the company’s ordinary shares. At current levels we believe we can generate double digit returns even without a recovery in cosmetics.
Commentary
large settlements. Analysts assume anywhere between zero and $10 billion. What we do know is that we do not know what the final outcome will be. To invest in RB today, one has to take a view on the litigation. This change in facts meant that our investment thesis had been undermined. As such, and despite the short holding period, we sold the shares and incurred a loss of 0.4% on the fund.
Outlook
International stocks have rarely been as attractive as they are today. On a forward price-to-earnings (P/E) basis, the S&P 500 is now trading at a premium of over 40% to MSCI EAFE markets. While it is true that the US is typically more expensive than the rest of the world, the historic premium has been closer to 15%[1]. The S&P’s current P/E ratio of 21 times seems to reflect an extrapolation of high earnings growth experienced in the past. This requires a heroic set of assumptions. In a recent paper, the Fed’s Michael Smolyansky pointed out that non-financial companies in the S&P 500 grew real earnings per share by 2.0% per year between 1962 and 1989. From 1989 to 2019 this has accelerated to 3.8%. Over the same periods growth in real EBIT per share has decelerated from 2.4% per year to 2.2%. Importantly, over both periods, EBIT has grown by less than GDP. How come earnings growth accelerated over the last 30 years while EBIT per share growth did not? The answer is that the entire outperformance at the earnings level came from falling interest rates and taxes. With effective taxes of the S&P firms at 15% in 2019 and interest rates still at historically low levels, this tailwind will not get repeated. Even the belief that taxes will stay at 2019 levels seems optimistic to us given the US’ huge fiscal deficit. Any investor who believes that the market can grow real earnings by more than real GDP over the long term is probably fooling themself. We struggle to see a scenario where this bleak growth outlook is consistent with the current S&P 500 P/E at 21. Most likely US investors are in for a disappointment. International markets also benefited from falling interest rates and taxes, but their valuation at 14.8 P/E is much more reasonable. With high growth unlikely to be repeated, valuations matter. The strategy is currently trading on a forward P/E of nine times and we remain excited about the opportunities we see in international markets.
[1] Median since 2006.
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