MS Global Franchise Fund Q3 2014 Commentary

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Dec 02, 2014

Performance Review

In September, the Global Franchise Portfolio returned -2.20%, outperforming the MSCI World Index, which returned -2.71%. For the third quarter, the Portfolio returned -1.79%, outperforming the index, which returned -2.16 %. Year to date, the Portfolio has returned 3.65%, underperforming the index, which returned 3.89%.

The Portfolio’s relative outperformance in September primarily stemmed from zero allocations in energy and materials. Stock selection in consumer discretionary and health care, underweights and stock selection in information technology and financials, and an overweight in consumer staples also contributed to relative outperformance. These positives were partly offset by stock selection in consumer staples and industrials. A health care underweight also detracted from relative performance for the month.

In the third quarter, the Portfolio’s zero weights in energy, materials and utilities, along with stock selection and underweights in the consumer discretionary and industrials sectors, added to relative performance. Stock selection in financials and health care and an overweight in information technology also added to relative return during the quarter. These contributions were partly offset by stock selection in consumer staples and information technology and an underweight in health care, which detracted.

Market Review

A number of different themes dominated financial markets during the quarter. These included deflationary pressures and the ongoing economic softness in the Eurozone, signs of weakening in China’s economy and the approaching end of the Federal Reserve’s asset purchase program. The US dollar (USD) stood out for its strength, with the MSCI World Index actually rising 0.8% in local currency, compared to a 2.2% decline in USD terms.

North America was the only global region whose equities finished the quarter in positive territory in USD terms. The Far East fell about 2% and Europe declined 7%, weighed down by significant double-digit declines in Portugal, Austria and Germany and marked weakness in the Euro. In local currency terms, Europe fell slightly and the Far East rose just under 5%.1

On a sector basis, information technology and health care had positive returns in USD terms for the quarter. Financials declined, but outperformed the broader market. Consumer staples, consumer discretionary and industrials declined, but held up better than utilities and materials. However, the key laggard was energy.

Outlook

The three decades running up to the 2008 global financial crisis were very favorable for many investors, partly due to political tailwinds. New parts of the globe became open to profits as communist systems disappeared, either by law (in Eastern Europe and Russia) or practicality (China). Western governments were also very market friendly. They took on inflation, driving it down along with nominal interest rates. They boosted valuations and bought into the primacy of markets, with privatizations bringing new sectors into the public markets. Capital was generally favored over labor, boosting profits at the expense of real wages and thus raising inequality. However, liberalization of financial markets mitigated the downside, as the doubling of debt/gross domestic product (GDP) ratios across the west allowed living standards to outperform wages.

The party didn’t end well, and the hangover has been both painful and drawn out. The good news is that at some point all hangovers come to an end. The question is, what sort of world, and particularly what sort of political environment, will businesses and investors face once the detox is done? Markets suggest that the favorable times will resume, given that equities are trading at the same forward multiples as they did in 2007, on high margins, and supposedly ‘high-yield’ bonds no longer offer high yields. We are rather less optimistic.

One category of political risk is geopolitical, be it Russia trying to rebuild its sphere of influence, China squabbling with Japan about uninhabited islands, the intricacies of the Middle East or the threat to the Euro. We don’t claim to have any special insights on these events other than to suggest that geopolitical risk is always with us, only the perception varies. As mentioned above, the markets in general seem pretty relaxed right now, with the prize for heroic indifference going to those who treat Euro sovereign debt as pretty similar, regardless of who is on the hook to actually repay it. The idea of lending 10-year money to the Italian government at 2.3%, cheaper than the equivalent Treasuries2, seems brave given serious questions about that country’s ability to sustain its debt burden.

An additional problem is how indebted governments will deal with their debt mountains. Ideally, the public debt/GDP ratio would be reduced by fast economic growth and the surpluses, or at least modest deficits that can come with a strong economy. In the absence of this happy scenario, ensuring negative real interest rates is arguably necessary, either by buying government bonds or by trapping money within countries through exchange controls. Either way, low real risk-free rates of return imply low return rates on all assets – particularly following the strong re-rating of the last three years.

The third area that concerns us is governments becoming more willing to interfere with companies’ efforts to make money. The steady pressure on median western living standards during the last few decades has become far more acute due to the global financial crisis and has spawned populist politics on both the left and right. Populist movements are springing up and/or growing across the west, be they the Tea Party in the US, UKIP in the UK, the Front National in France, Beppe Grillo’s 5 Star movement in Italy or even the AfD in Germany – not to mention the separatist movements in Scotland and Catalonia. Though the different movements have their own particular quirks, they all tap into populist distaste for the behavior and habits of ‘the elite.’

As yet, these political movements are all some way away from power, which in many cases is vital for the continued survival of the Euro, but they are influencing the behavior of established players and threatening the alliance between large businesses and governments that characterized the pre-crash period. At the moment, governments are tending to pick on vulnerable and weak companies that have strayed from the safety of the corporate herd. Utilities, unable to move their plants, have been hit by tax increases and threats of price freezes, while the banking sector has been forced to pay $170 billion for the sins of its past, with more to come, alongside assorted other levies. Minimum wages are being introduced, as in Germany, or raised, perhaps showing a swing back to favoring labor over capital. Companies paying little tax are in the sights of governments, although so far there’s been more noise than action. Fortunately to date, pressure on immigration has yet to metastasize into protectionism, as at least one lesson has been learned from the 1930s, but this still remains a longer term threat.

Even if some of the worst case scenarios suggested above do not come to pass, it is clear that the political environment may not be as favorable as the tailwinds enjoyed during the three decades leading up to the global financial crisis. This adds to our concern about the current frothy multiples on high earnings, which worryingly seem to be based on a rose-tinted view of the world’s prospects.

The Global Franchise fund seeks to analyze perceived absolute risks and the consequent risk of losing money. Regarding political risk, we strive to apply the framework below in an attempt to carefully assess the possibility of losses at the hands of governments:

·Be wary of geographically non-diversified companies for fear of the damage a single government can do.

·Prefer companies that have strong market share and pricing power, so that higher costs can be passed on to consumers.

·Prefer companies that do not have excess operational or financial leverage, so that any pain not passed on to others has limited effect on profitability and solvency.

·Be wary of companies with very low tax rates on either earnings or cash.

·Carefully consider whether the level of political risk is reflected in the price.

With the exception of the tax element, the other four bullet points are all specific examples of our general philosophy. We worry a great deal about absolute risk, and by risk we mean the threat of losing money rather than some relative measure. We prefer companies with higher returns on unlevered capital and without excess financial or operational leverage, which we endeavor to buy at a reasonable price.

This does not mean that political risk should or can be avoided altogether. In fact, periods of excessive fear of political action can offer attractive entry points to otherwise expensive companies. For example, in 2010, the Durbin legislation on US debit cards hit Visa (V) far harder than it should have, allowing us to build a position in the stock. The proposed changes only affected the US, only targeted debit (leaving credit alone), and would generally have hurt the banks’ segment of the value-chain far more than Visa and MasterCard. Yet Visa dropped over 25%3, to the point where we could still see upside even in the extremely unlikely event that the US debit business disappeared altogether.

A more longstanding case is tobacco, which has been in government sights for four decades. Tobacco consumption in western markets has fallen by about 3% per year as governments have raised taxes and restricted advertising and usage. Nevertheless, tobacco companies have prospered during this period as their pricing power allowed them to raise prices by about 5% per year3. A highly concentrated industry selling an addictive product where the bulk of the cost is tax, with governments raising the tax every year, has allowed the strong pricing. As with all holdings, we remain alert to political risks, most notably regulations requiring plain packaging, which could hurt pricing ability, but we remain positive about the industry, particularly given the 15%3 discount the tobacco subsector has to the consumer staples sector as a whole.

As we have stated above, markets are at high levels despite assorted clouds on the horizon. The strong equity performance in the last three years has been overwhelmingly due to re-rating rather than earnings growth. This has reduced the margin of safety for the market as a whole, and also for the higher quality companies we focus on in the Portfolio. Though we have become more confident about high quality equities in relative terms because they have not re-rated as fast as the lower quality stocks, we have become less comfortable in absolute terms as they too have become more expensive. The Portfolio’s 2015 Free Cash Flow Yield of 5.6% does not seem unreasonable given the quality of the assets and looks attractive compared to the 5.2% offered by the far lower quality market as a whole.3 However, it would be foolish to assume that the Portfolio would not be affected by any sharp downward move in the overall market, and the risk of such a move has risen with the rising valuations.