Commentary
The fund had a good quarter, rising by 14.9%. 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 32.2% 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 6% to now 9.1x.
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.
Portfolio activity in Q4
During the fourth quarter we sold Newcrest Mining and initiated positions in Michelin, Shell and Brembo. Newcrest was sold shortly before closing of the acquisition of the company by American rival Newmont.
Michelin is the largest global tyre manufacturer. The company generates around half of sales from the passenger car market, with the remainder split equally between trucks and specialty vehicles, including mining and aircraft tyres. The low end of the tyre market is commoditised, but Michelin is largely insulated as they play on the premium end where customers care about performance and are willing to pay for it. Michelin tyres have industry leading performance metrics and tend to be priced at a 10% premium. The initial purchase of a set of Michelin tyres is often indirect, with customers choosing to buy e.g. a Porsche which happens to come with a set of Michelin tyres. When those tyres are up for replacement after around four years, customers tend to stick with the Michelin brand – why buy a cheaper set of tyres to save $200 when it may compromise performance of your +$100,000 car? It is no coincidence that many premium cars come with Michelin tyres. The company spends a great deal of time and money to meet premium OEM's strict performance requirements. Hence, while anyone can produce low-end tyres, the premium end of the market has formidable barriers to entry.
Michelin is likely to benefit from industry tailwinds over the next few years. First, the move to electric vehicles means that tyres gain in relative importance. This is because factors such as rolling resistance become more relevant. With cheap tyres an electric vehicle may not achieve the advertised mileage. A second tailwind is more stringent regulation, including CO2 and microplastic emissions – Michelin performs well on both metrics and cheaper brands struggle to compete. These trends make it likely that Michelin can defend their market share and pricing premium.
Given its brand and pricing power, Michelin has a history of passing raw material costs on to customers, resulting in stable operating margins of 10-12% and return on invested capital of around 10%. With 75% of tyres sales coming from the replacement market, this is also not a particularly cyclical business. We were able to buy Michelin at a historically high free cash flow yield of almost 10% which in our view does not reflect the quality and earnings profile of the business.
We partly funded the purchase of Shell, the oil & gas company, through a reduction in our position of BP, spreading the risk across two companies. The combined holding amounts to a 6.4% position. Both Shell and BP are very attractively valued, with their free cash flow yields in the low teens. They are returning most of the free cash flow to shareholders through dividends and buybacks.
Brembo is an Italian manufacturer of automotive braking systems. It has specialised in braking solutions since it was founded in 1961 by Alberto Bombassei who remains the majority shareholder. Brembo is a global business with most of its solutions going into passenger cars.
Brembo’s key products are brake disks and calipers. Its brightly coloured calipers can be seen behind the wheels of most premium and luxury cars and are considered a status symbol among car enthusiasts. Brembo is the clear global leader in calipers for the premium and luxury segment with around 80% market share. It is sole supplier to the likes of Ferrari and it supplies all Formula 1 racing teams.
The near-monopoly position in high-end calipers is unusual among auto suppliers, traditionally a cut-throat industry. This position has been built over decades, leveraging Brembo’s first-mover advantage in high-end calipers to build global scale in production and research & development. With Brembo’s scale, reputation, brand and innovation, it is extremely challenging for competitors to catch up. The strong competitive position allows Brembo to extract premium pricing, leading to double digit operating margins and returns on capital.
Over the last ten years, Brembo has grown revenues by more than 10% annually driven primarily by two factors. Firstly, Brembo has moved from supplying primarily luxury cars to also supplying premium cars. Secondly, the shift to electric vehicles has been helpful as it has driven premiumisation. To meet demand, Brembo is investing significantly to expand production capacity. Over the next two to three years, Brembo will increase capacity by 10% annually with 80% of the capacity already covered contractually. We believe Brembo’s valuation at 11x price-to-earnings does not account for the company’s entrenched market position and growth profile.
Outlook
2023 was a relatively eventful year. We had a banking crisis that ultimately claimed Silicon Valley Bank, Signature Bank, First Republic Bank and Credit Suisse as victims, and triggered some of the biggest bond market moves in decades. We witnessed growing excitement about the potential for Artificial Intelligence and promising new GLP-1 obesity drugs. We also saw the rise of the ‘Magnificent 7’ (Alphabet, Apple, Meta, Microsoft, Amazon, Nvidia, Tesla), which drove a major outperformance of big tech in the US.
Political challenges were prevalent throughout the year. In the US, we saw broad dysfunction ahead of a last-minute bipartisan deal to raise the debt ceiling. This was later followed by the defenestration of the House Speaker and a chaotic race to find a replacement. Internationally, the war in Ukraine continued to grind on without much sign of a diplomatic off-ramp, while US-China tensions remained elevated and sparked more import/export restrictions. In October, Hamas attacked Israel, resulting in the invasion of the Gaza strip. Most recently, we have seen Houthi attacks on shipping in the Red Sea. Tensions in the Middle East remain elevated.
The year concluded with a remarkable rally across various asset classes from late October, as declining inflation led investors to grow increasingly excited about a soft landing. This optimism gained further momentum in December following the Federal Reserve's indication of rate cuts in 2024. As such, we ended 2023 with many stock indices above or very close to all-time highs, bonds that returned 5% following an historic two-year bear market, and a gold price that went through $2000/oz for the first time ever.
Although many stock indices around the world ended above or close to all-time highs, there is a material divergence in relative valuations. The US is looking expensive, trading on valuations that are significantly above long-run averages. However, this is not true of non-US markets, which look far more attractive. This is encapsulated in the chart below which shows the cyclical adjusted price-to-earnings (CAPE) ratio of the US versus the World ex-US. The CAPE is a good long-term indicator of future returns, and the chart shows just how extreme and unusual the current situation is.
There is also a material divergence in relative valuations when looking at Value versus Growth. Today, the MSCI World Growth Index trades on a price-to-earnings multiple of 32x, having re-rated from 20x over the last decade. In comparison, the MSCI World Value Index trades on 14x and has seen no rating change over the last decade. The implication is that the MSCI World Growth now trades at a record premium to MSCI World Value.
We try not to make too many predictions about the wider macro environment. Instead, we focus on companies, valuations, and invest with a long-term mind-set. We select investments through a bottom-up, research-driven approach, searching for companies which have attractive business attributes and are trading at a significant discount to intrinsic value. We are contrarian in our thinking, looking at parts of the market that are unloved and out of favour. Areas of poor sentiment are where we find companies priced at material discounts to intrinsic value. However, looking in such areas can be emotionally challenging; people like the comfort of being part of the crowd. Nevertheless, we remain committed to this approach.
We enter 2024 with a fund that is currently trading on a forward price-to-earnings multiple of just 9.1x. This compares to the MSCI EAFE index on 13.2x. In addition, the portfolio’s weighted average upside of 50% is attractive relative to history. We believe that the relative starting valuations of the portfolio and wider markets, the attractive portfolio upside, and the relatively poor sentiment surrounding International markets and Value investing, sets up for a favourable outlook.
Commentary
The fund had a good quarter, rising by 14.9%. 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 32.2% 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 6% to now 9.1x.
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.
Portfolio activity in Q4
During the fourth quarter we sold Newcrest Mining and initiated positions in Michelin, Shell and Brembo. Newcrest was sold shortly before closing of the acquisition of the company by American rival Newmont.
Michelin is the largest global tyre manufacturer. The company generates around half of sales from the passenger car market, with the remainder split equally between trucks and specialty vehicles, including mining and aircraft tyres. The low end of the tyre market is commoditised, but Michelin is largely insulated as they play on the premium end where customers care about performance and are willing to pay for it. Michelin tyres have industry leading performance metrics and tend to be priced at a 10% premium. The initial purchase of a set of Michelin tyres is often indirect, with customers choosing to buy e.g. a Porsche which happens to come with a set of Michelin tyres. When those tyres are up for replacement after around four years, customers tend to stick with the Michelin brand – why buy a cheaper set of tyres to save $200 when it may compromise performance of your +$100,000 car? It is no coincidence that many premium cars come with Michelin tyres. The company spends a great deal of time and money to meet premium OEM's strict performance requirements. Hence, while anyone can produce low-end tyres, the premium end of the market has formidable barriers to entry.
Michelin is likely to benefit from industry tailwinds over the next few years. First, the move to electric vehicles means that tyres gain in relative importance. This is because factors such as rolling resistance become more relevant. With cheap tyres an electric vehicle may not achieve the advertised mileage. A second tailwind is more stringent regulation, including CO2 and microplastic emissions – Michelin performs well on both metrics and cheaper brands struggle to compete. These trends make it likely that Michelin can defend their market share and pricing premium.
Given its brand and pricing power, Michelin has a history of passing raw material costs on to customers, resulting in stable operating margins of 10-12% and return on invested capital of around 10%. With 75% of tyres sales coming from the replacement market, this is also not a particularly cyclical business. We were able to buy Michelin at a historically high free cash flow yield of almost 10% which in our view does not reflect the quality and earnings profile of the business.
We partly funded the purchase of Shell, the oil & gas company, through a reduction in our position of BP, spreading the risk across two companies. The combined holding amounts to a 6.4% position. Both Shell and BP are very attractively valued, with their free cash flow yields in the low teens. They are returning most of the free cash flow to shareholders through dividends and buybacks.
Brembo is an Italian manufacturer of automotive braking systems. It has specialised in braking solutions since it was founded in 1961 by Alberto Bombassei who remains the majority shareholder. Brembo is a global business with most of its solutions going into passenger cars.
Brembo’s key products are brake disks and calipers. Its brightly coloured calipers can be seen behind the wheels of most premium and luxury cars and are considered a status symbol among car enthusiasts. Brembo is the clear global leader in calipers for the premium and luxury segment with around 80% market share. It is sole supplier to the likes of Ferrari and it supplies all Formula 1 racing teams.
The near-monopoly position in high-end calipers is unusual among auto suppliers, traditionally a cut-throat industry. This position has been built over decades, leveraging Brembo’s first-mover advantage in high-end calipers to build global scale in production and research & development. With Brembo’s scale, reputation, brand and innovation, it is extremely challenging for competitors to catch up. The strong competitive position allows Brembo to extract premium pricing, leading to double digit operating margins and returns on capital.
Over the last ten years, Brembo has grown revenues by more than 10% annually driven primarily by two factors. Firstly, Brembo has moved from supplying primarily luxury cars to also supplying premium cars. Secondly, the shift to electric vehicles has been helpful as it has driven premiumisation. To meet demand, Brembo is investing significantly to expand production capacity. Over the next two to three years, Brembo will increase capacity by 10% annually with 80% of the capacity already covered contractually. We believe Brembo’s valuation at 11x price-to-earnings does not account for the company’s entrenched market position and growth profile.
Outlook
2023 was a relatively eventful year. We had a banking crisis that ultimately claimed Silicon Valley Bank, Signature Bank, First Republic Bank and Credit Suisse as victims, and triggered some of the biggest bond market moves in decades. We witnessed growing excitement about the potential for Artificial Intelligence and promising new GLP-1 obesity drugs. We also saw the rise of the ‘Magnificent 7’ (Alphabet, Apple, Meta, Microsoft, Amazon, Nvidia, Tesla), which drove a major outperformance of big tech in the US.
Political challenges were prevalent throughout the year. In the US, we saw broad dysfunction ahead of a last-minute bipartisan deal to raise the debt ceiling. This was later followed by the defenestration of the House Speaker and a chaotic race to find a replacement. Internationally, the war in Ukraine continued to grind on without much sign of a diplomatic off-ramp, while US-China tensions remained elevated and sparked more import/export restrictions. In October, Hamas attacked Israel, resulting in the invasion of the Gaza strip. Most recently, we have seen Houthi attacks on shipping in the Red Sea. Tensions in the Middle East remain elevated.
The year concluded with a remarkable rally across various asset classes from late October, as declining inflation led investors to grow increasingly excited about a soft landing. This optimism gained further momentum in December following the Federal Reserve's indication of rate cuts in 2024. As such, we ended 2023 with many stock indices above or very close to all-time highs, bonds that returned 5% following an historic two-year bear market, and a gold price that went through $2000/oz for the first time ever.
Although many stock indices around the world ended above or close to all-time highs, there is a material divergence in relative valuations. The US is looking expensive, trading on valuations that are significantly above long-run averages. However, this is not true of non-US markets, which look far more attractive. This is encapsulated in the chart below which shows the cyclical adjusted price-to-earnings (CAPE) ratio of the US versus the World ex-US. The CAPE is a good long-term indicator of future returns, and the chart shows just how extreme and unusual the current situation is.
There is also a material divergence in relative valuations when looking at Value versus Growth. Today, the MSCI World Growth Index trades on a price-to-earnings multiple of 32x, having re-rated from 20x over the last decade. In comparison, the MSCI World Value Index trades on 14x and has seen no rating change over the last decade. The implication is that the MSCI World Growth now trades at a record premium to MSCI World Value.
We try not to make too many predictions about the wider macro environment. Instead, we focus on companies, valuations, and invest with a long-term mind-set. We select investments through a bottom-up, research-driven approach, searching for companies which have attractive business attributes and are trading at a significant discount to intrinsic value. We are contrarian in our thinking, looking at parts of the market that are unloved and out of favour. Areas of poor sentiment are where we find companies priced at material discounts to intrinsic value. However, looking in such areas can be emotionally challenging; people like the comfort of being part of the crowd. Nevertheless, we remain committed to this approach.
We enter 2024 with a fund that is currently trading on a forward price-to-earnings multiple of just 9.1x. This compares to the MSCI EAFE index on 13.2x. In addition, the portfolio’s weighted average upside of 50% is attractive relative to history. We believe that the relative starting valuations of the portfolio and wider markets, the attractive portfolio upside, and the relatively poor sentiment surrounding International markets and Value investing, sets up for a favourable outlook.
Commentary
Despite convincing arguments in favour of RB, the jury ruled in favour of the plaintiff Ms Watson. She was awarded a headline sum of $60 million. RB’s reaction to the verdict was one of ‘surprise’ and ‘disappointment’. RB will now appeal the ruling. RB and competitor Abbott are facing c. 400 cases in federal court and additional litigation in state courts.
Over recent years we have followed several companies with exposure to mass consumer litigation in the US. What we have learnt is that the number of claims is likely to rise materially after a large initial jury verdict. We have also learnt that having the science in your favour is not enough. In the end, judges and juries decide court cases, not scientist. Often these cases end with 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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